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 may result in lower estate value and higher lifetime taxes compared to your current plan depending upon the limit you choose.The Explorer will not inform you if it is not able to provide a plan that achieves the goal compared to your current plan. As a result, you may see a negative result when using the rule based strategies.
Additional Details
The Roth Conversion Explorer strategy removes all 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.
Conversions are suggested from the account with the highest rate of return first. You may adjust the suggested order by changing the rate of return. The secondary ordering rule is the account owner and the third is alphabetical.
The Explorer does not consider the Affordable Care Act/Premium Tax Credits.
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.
Savings balances are not adjusted for tax.
Tax rates are based on the assumption you select in My Plan > Assumptions > Taxes
529 and HSA accounts are excluded.
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 software does not feature the Affordable Care Act. You may add the reduction in/loss of tax credits due to conversions as an expense.
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.
When you create a Roth Conversion in Money Flows, the Planner creates a new account entitled Roth Conversions. You do not have the ability to modify the growth rates for this account or model any distributions from the account.
If you prefer to convert to your own Roth, you may use the Transfer feature and the tax computation will be the same.
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 IRA, 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 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. Once the date of a conversion is past, the tax liability will remain but you must adjust your account balances. The conversion will be ignored when you run the Explorer because it ignores all conversions currently entered. For this reason, you will be unable to make assumptions for 2024 based on the Explorer if you have already performed conversions for this year.
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.
You may also want to explore our standalone Roth Conversion Calculator.