What is a Roth Conversion?
A Roth conversion is the process of transferring money from a tax-deferred account to a Roth IRA, where the growth will not be taxed. So, Roth Conversions provide an opportunity to move money out of a pre tax account, pay tax at times that are favorable to you and not the IRS, and get the money into a Roth where it will never be taxed again.
What are the assumptions underlying the Roth Conversion Explorer?
The Explorer will solve for one of four strategies
Goal Based Strategies: Highest Estate Value and Lowest Lifetime Tax
When choosing the highest estate value strategy and the lowest lifetime tax strategy, the Explorer will cycle through hundreds of iterations of projections and identify a series of conversion that achieves the stated goal.
The Explorer will inform you if it is not able to provide a plan that achieves the goal compared to your current plan.
There is, though, a threshold which limits annual conversions to your plan’s maximum effective tax rate. This means that you may be able to achieve a higher estate value strategy or lower lifetime tax rate manually with your own manual plan or one of the Rule Based strategies.
Rule Based strategies: Tax Bracket Limit and IRMAA Limit
The rule based strategies will respect thresholds and may result in a lower estate value or higher lifetime tax liability depending upon the limit you choose. So you may see a negative result but you will not receive a message stating that they could not find a better solution for you, rather you will always see a result because you have set the threshold.
The tax bracket limit strategy will fill the bracket each year for as long as possible, so it’s a front loaded strategy. The IRMAA bracket strategy will flow through your entire plan and fill up the lowest tax brackets from age 63 through longevity age before moving on to the higher bracket, so it’s more of a smoothing strategy.
Additional Details
The Roth Conversion Explorer strategy removes all future modeled Roth Conversions in your Plan before generating a suggestion.
If your after-tax accounts have a higher growth rate than your tax-deferred accounts, the Explorer may not suggest an optimized plan because allowing the after tax money to grow may result in a higher net worth.
The Explorer assumes that the converted funds will grow at the same rate as the current tax deferred account. You’ll notice that the Conversions will be held in a Virtual account, which has the rate of return of the source account and cannot be accessed in our current model. We do plan to add the ability to convert to your own Roth soon.
The Explorer’s logic for selecting source accounts is to select the pre-tax account with the highest rate of return, as this provides the most tax-free growth. If there are two accounts with the same rate of return, the order will prioritize by primary user and alphabetically.
Savings balances are not adjusted for tax.
Tax rates are based on the assumption you select in My Plan > Assumptions > Taxes
Roth conversions will not be suggested if the tax payments reduce the after-tax funds below the protected amount specified in your plan or lead to an unfunded One Time Expense, Disbursement, or Transfer. You may want to run the Explorer prior to adding those items. You do always also have the option of including One Time Expenses and Disbursement in the recurring budgeter to avoid this issue.
Roth conversions will not be suggested if the tax payments reduce the after-tax funds below any protected amount.
The Explorer makes an assumption that all Traditional IRA accounts and all other pre-tax accounts are eligible for conversion. This may be an issue if you have an Inherited IRA or other non-eligible tax-advantaged accounts modeled in your plan. In that case you should exclude the account from the withdrawal strategy.
The Explorer does not consider Early Distribution Penalties or the 5-year rule.
The Explorer will not suggest conversion in your 401k prior to age 59.5 when you have income linked contributions directed to the 401k.
If you do not have enough funds in after-tax accounts to cover the tax liability prior to age 59 ½, conversions will not be suggested.
After age 59 ½ the optimized plan will utilize converted assets to pay the taxes on the conversion after after-tax assets have been depleted.
The software does not feature the Affordable Care Act/Premium Tax Credits. You may add the reduction in/loss of tax credits due to conversions as an expense.
529 and HSA accounts are excluded.
What are the assumptions underlying Roth Conversions in Money Flows?
Prior to age 59 ½ the planner will drain 100% of your taxable assets to pay the taxes. This may not be what you want/intend to do.
If you are converting prior to age 59 ½, you may be subject to a penalty for early withdrawal. This is not calculated in the Planner but you will get a coach alert.
Roth Conversions do not satisfy RMD requirements.
When modeling conversions, the after tax accounts account(s) will be tapped to cover the taxes as long as available. If you would like to model the tax coming from the source account, you have a couple of options.
You may want to exclude the after tax accounts from withdrawals so that pre tax accounts will be tapped to fund taxes once the after tax accounts are depleted. We don't suggest increasing the conversion modeling to account for this.
If you wish to leave the after-tax accounts open to pay expenses, you should model the Roth Conversion as a Transfer to a Roth account. And then add a Transfer from the Roth account to a cash account that funds expenses.
See this video to learn how to Model Roth Conversions in My Plan > Money Flows
How are the taxes on Roth Conversions paid?
When you perform a Roth Conversion the assumption is that you are paying taxes from outside of the IRA first. The taxes are paid in accordance with our plan order of operations and withdrawal order. If additional funds are needed, the Planner will use funds from the source IRA being converted (conversion proceeds) if you make that selection.
How are current year conversions taken into account?
If you have made a partial conversion early in the year, enter the conversion in the prior month and the Explorer will surface your remaining opportunity. Once the date of a conversion is past, the tax liability will remain but you must adjust your account balances.
It's essential to use your own discernment and consider your investing and planning temperament prior to executing any financial strategy. We also recommend that you validate your strategies with a tax professional or your tax software prior to taking action.
You may also want to explore our standalone Roth Conversion Calculator.