Jason Method: One beneficial aspect of our current retirement system is that it allows you to choose when to pay taxes on at least some of the money you’ve saved. Pay now or pay later, that is the question. Because of the new lower federal income tax rates, many financial planners think retirement savers should give further consideration to the pay now option, but is that right for you?

Hello, and welcome to Vanguard’s Investment Commentary podcast series. I’m Jason Method. In this month’s episode, which we’re taping on October 16, 2018, we’re going to help listeners understand why and under what circumstances a Roth conversion may be valuable to them.

Joining us today is Vanguard Wealth Planning Specialist Boris Wong. Boris has written an insightful white paper that calculates when it is better from a tax perspective to convert pretax retirement savings into after-tax savings in a sheltered Roth account.

Hello, Boris, and thanks for joining us.

Boris Wong: Hi, Jason. It’s good to be here.

Jason Method: First, let’s quickly make sure all the listeners are up to speed on this topic. What is a Roth conversion and how would an investor do one?

Boris Wong

Boris Wong: Well, a Roth conversion takes all or part of the balance of a traditional IRA and moves that to a Roth IRA. And, actually, in addition to IRA, many employer plans like 401(k)s, they now have Roth saving options as well. And some of them even have in-plan Roth conversions, meaning that you can convert a traditional 401(k) to a Roth 401(k). And doing Roth conversion is actually very easy. So let’s say you have a traditional IRA, all you have to do is to log onto your traditional IRA account, and there should be an option there for you to do the conversion.

The downside of a Roth conversion is that you have to pay taxes now. So you’re accelerating a tax liability from the future to today, but the benefit is that you don’t have to pay taxes anymore on that conversion amount and also any of the earnings you earn in the future.

Jason Method: So when you’re thinking about your taxes then, when does this make sense?

Boris Wong: Well the traditional rule of thumb is still a good starting point, and that is you’re comparing today’s marginal tax rate versus your retirement marginal tax rate. So if you expect to have a higher tax rate in the future, in retirement, then it’s better for you to pay taxes now and do the Roth conversion now so that you can take advantage of the low tax rate today. And if you expect the tax rate to stay the same, then you’ll be indifferent.

Jason Method: Okay, so why would you be indifferent if you expect your tax rate to stay the same? If you have a Roth and you’re never getting taxed again, so to speak, wouldn’t that be the preferred option?

Boris Wong: Well let’s think of an example this way. So let’s say you earn $100 and you want to save that. And to make it easy, let’s just assume that the tax rate’s 50% and it’s flat over time. Well in this case, if you’re saving in a traditional IRA, you can have a deduction upfront. So your $100 savings, your 50% tax rate, you can save $50 in taxes, so meaning that you actually don’t have to pay any taxes for that $100 upfront. And let’s say the investment doubled to $200, and then you have to pay taxes when you withdraw at 50% tax rate. So $200, you pay $100 in tax. You have $100 left after tax.

For a Roth, you do have to pay taxes upfront. So with the $100 in savings, you have to pay $50 upfront. So that means you have $50 to begin. And even if the investment doubled to 100, you don’t have to pay taxes at the back end, you still only have $100 after tax. So you can see that in this case, either way, with a flat tax rate, the traditional and the Roth, they’ll both have the same after-tax balance at the end.

Jason Method: Gotcha. Even those 50% sounds pretty high, in the end, you’re talking about investing and not having any gain with your $100. At the end of the day, the reality is that no matter what tax rate, you’re going to end up with the same. If it’s the same tax rate now, the same tax rate later, you’ll end up with the same amount in retirement.

Boris Wong: Correct.

Jason Method: But, of course, we’re uncertain about the future, right? So if I’m uncertain about my future tax rate, does a Roth conversion still make sense?

Boris Wong: Yes, it does. And that’s when a partial Roth conversion can make sense. By doing a partial Roth conversion, you earn the benefit of a tax diversification where you can hold both a traditional account and a Roth account.

Jason Method: And so later on you can pick and choose which accounts to use.

Boris Wong: Correct, and you can have a lot more strategies in the future where you can, if you think about future withdrawals at retirement, based on the tax rate you may want to withdraw from a traditional or the Roth, so you have different options.

Jason Method: Right, and we’ll get into some of that later, but your paper talks about how your decision point on this, right, the break-even tax rate, so to speak, can be even lower than your current tax rate in some situations. Tell us about that.

Boris Wong: Right, so our paper basically give up some scenarios where you can have, actually, a lower tax rate in the future and Roth conversion may still make sense. One of them is by how you pay the conversion tax. So if you pay the conversion tax using funds in your retirement account, then this goes back to traditional rule of thumb where you are indifferent if the tax rates stay the same. But if you can pay the taxes from a taxable account, such as a checking account, a savings account, or a brokerage account, then that break-even tax rate would be lower.

Jason Method: And why is that?

Boris Wong: Well, you have to remember that in a taxable account, all those earnings would be taxed every year. So, for example, if you have interest income, you would be taxed at the ordinary income tax rate, which is higher than capital gains tax rate. And even if you have dividends and realize capital gains, you still have tax every year when they’re realized, instead of a retirement account where you can defer all the way until withdrawals. So that creates all this tax drag every year.

Jason Method: Are there any other reasons why a Roth conversion can make sense?

Boris Wong: Right, there are two other scenarios. So one would be if you have basis in traditional IRA and the second would be to opening like more options and doors for future Roth conversions. So the first one, if you have high enough income in the past, then you may have made nondeductible traditional IRA contributions. And that nondeductible part, or the basis, would be when you do the Roth conversion, you don’t have to pay taxes again for that part. So that lowered the cost of a Roth conversion.

Jason Method: And you’re talking about someone whose income level is beyond the traditional IRA limits so they’re just putting in money after tax into an IRA?

Boris Wong: That’s correct. And the second part is to open door for future Roth conversions. So if you expect to have high income in the future, right, and maybe when you do a traditional IRA, again, you’ll face that income limit so that you cannot take a deduction. In that case, what you want to do, because a nondeductible IRA savings is not that efficient compared to if you do the nondeductible contributions but then do a Roth conversion afterwards so that you can convert all those nondeductible parts to Roth and mix all the earnings tax free going forward. So doing the Roth conversion now may make it easier for you to do all those subsequent conversions in the future and make your future savings more tax-efficient.

Jason Method: As we think about retirement and retirement options, there’s more that comes into play with this, how can this help later in retirement when we think about taxes on Social Security or with Medicare benefits?

Boris Wong: Yes, that’s a great point. So another benefit of the Roth IRA is that it doesn’t have RMD or the required minimum distributions. And also any qualified withdrawals from the Roth IRA is not counted as taxable income. So what that means is that by having a Roth IRA, doing the conversion now and moving money to a Roth, you can potentially lower your taxable income at retirement. And that means that you can potentially avoid the higher Medicare premium surcharge and also the taxation of Social Security benefits. And that can be a great topic for you to talk to financial advisors.

Jason Method: The feature of it not being recognized as income is a big one.

Now, let’s think about this in the big picture and in the long term for a minute. You know, we just had a federal tax law that was passed last year that reduced tax rates across the board. And when you look back historically, some of the lower and middle tax brackets are as low or lower than they’ve been in decades.

In the 50s, for example, the taxes started at 20% of the first dollar earned, right, and then the marginal tax rate went all the way up to 91%. So in that big picture, when you think about it, is now a good time to convert?

Boris Wong: Well, it’s hard to tell because you can never know what the future tax rate will be. But given that we have a growing deficit and also that the tax cut that was passed last year was set to be expired, at least the individual tax component, most of that is set to be expired at the end of 2025, then I guess it may be reasonable for people to think that it’s more likely for the tax rate to be high in the future than it is for it to be lower. And if that’s the belief, then yes, Roth conversion would be even a better deal now.

Jason Method: Okay, and if you’re convinced of this, then if you want to do a conversion in the current tax year, when is the deadline to get this done?

Boris Wong: December 31, and make sure don’t confuse that with the contribution deadline, which would be April 15 of the following year.

Jason Method: Okay, so if I want to contribute to a traditional IRA, I have to do that by April 15. But if I want to convert to a Roth, it’s by the end of the year?

Boris Wong: Yes.

Jason Method: Okay, so celebrate New Year’s knowing that you’ve made a Roth conversion, right?

Are there any special rules around Roth conversions we need to be aware of?

Boris Wong: Yes, there’s the five-year rule for Roth conversion, and that determines whether that Roth conversion principle would be penalty-free. And each conversion starts its own five-year clock. And the year is by tax year. So what that means is that if you do a Roth conversion this year, any time this year, the clock would start on January 1, 2018. So when you get to January 1, 2023, then the five-year would be up and that would be the first day that the withdrawal would be penalty-free.

Jason Method: Okay, so that means if you want to take the money, you feel you need to take the money, then you would need to wait five years before, avoiding a 10% penalty, right?

Boris Wong: Penalty, yes.

Jason Method: Now, I mean people do feel anxious about sometimes having access to money because it’s life. You never know when there may be a medical emergency, a job loss, something in your life that you might need help with. Can you access this money after you’ve made a conversion if you decide to pay the taxes on it?

Boris Wong: Yes, there’s some exceptions for Roth IRAs. So, for example, you can take out, if you are buying a new home, you can take out $10,000 from the Roth IRA to do that; and there also are exceptions for like high medical expenses and qualified higher education.

Jason Method: Okay, but the penalty goes away after the age of 59-1/2, right?

Boris Wong: Correct.

Jason Method: Then you can access the money at any time.

Boris Wong: Right, so there’s no five-year rule or any other restrictions after 59-1/2.

Jason Method: Right. Now I think there was a provision in the new tax law too that affected Roth conversions. Can you help us out with that one?

Boris Wong: Oh, yes. So I think we are talking about the recharacterization. So prior to the change in the tax law last year, when you do a Roth conversion, you have the option to recharacterize, so basically moving from the Roth IRA back to a traditional IRA. But after the tax law that was passed last year, now we no longer have that option. So when you do the Roth conversion, it’s final. You cannot redo it.

Jason Method: Redo it. And many people did that, not because they just want to play paperwork games, but because the market went down. Their investment went down in value after the conversion, and they realized they could do a conversion again if they recharacterized it, but at a lower amount, right?

Boris Wong: That’s right.

Jason Method: As listeners can probably ascertain, but at this point there’s many rules and exceptions, differences in aspects about this. If people have questions or a little confused about how that works, what should they do?

Boris Wong: Well that would be a wonderful situation to talk to a financial advisor who would know your personal situation better and can walk you through all the different implications.

Jason Method: And certainly for our advisor audience, these rules and details are things to talk over with their clients as well.

Thanks for helping us sort through all of this, Boris.

Boris Wong: Thanks for having me.

Jason Method: No problem. Unfortunately, that’s all the time we have today. Thank you for joining us on this Investment Commentary podcast series.

To learn more about Vanguard’s thoughts on various financial topics, be sure to check out our website. There you can also read the white paper, “A BETR (B-E-T-R) Approach to Roth Conversions.” Also, check with us each month for more insights into the markets and investing. Remember, you can always follow us on Twitter and LinkedIn. Thanks for listening.

All investments are subject to risk, including the possible loss on the money you invest. Withdrawals from a Roth IRA are tax free if you are over the age of 59-1/2 and have held the account for at least five years. Withdrawals taken prior to age 59-1/2 or five years may be subject to ordinary income tax or a 10% federal tax penalty or both. A separate five-year period applies for each conversion and begins on the first day of the year in which the conversion contribution is made. We recommend that you consult a tax or financial advisor about your individual situation.

The information presented in this podcast is intended for educational purposes only and does not take into consideration your personal circumstances or other factors that may be important in making investment decisions. You may access and download this podcast only for your personal and noncommercial use. You may not use it in any other many or for any other purpose without Vanguard’s written permission. Copyright 2018, the Vanguard Group, Inc., all rights reserved.