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When Does it Make Sense to Do a Roth Conversion?

A reader writes in, asking:

“I have read that a Roth conversion is a good idea if I am currently in a lower tax bracket than the tax bracket I will be in during retirement. But real life appears to be more complicated than that, as we will be in differing tax brackets from one year to another during retirement. And I don’t think our situation is particularly unusual.

I expect to retire about 4-5 years from now, which will cause us to move into a lower tax bracket. My wife anticipates retiring a few years after that, which may cause us to move into an even lower tax bracket, where we will be for a few years, until we start taking Social Security and move back up into a higher tax bracket. At what point(s) would Roth conversions be favorable?”

Firstly, just to be clear on one point, we are more concerned with how your marginal tax rate will change over time, rather than how your tax bracket will change over time. (While they are often the same, they can differ due to things such as the way Social Security is taxed or due to ACA subsidies — or other tax breaks — phasing out over certain income ranges.)

With Roth conversions — and tax planning in general — the goal is often to “smooth out” your marginal tax rate, to the extent possible.

Overall, the planning process typically looks something like this:

  1. Forecast your future income on a year-by-year basis using a simple “dummy” scenario, in which you do no particular tax planning. (For example, no Roth conversions at any point, and each year’s spending in retirement comes proportionately from each type of account — Roth, tax-deferred, and taxable.)
  2. Calculate your marginal tax rate in each year going forward under the dummy strategy.
  3. Look for years in which your marginal tax rate is projected to be at its lowest point.
  4. Attempt to shift income from high-marginal-tax-rate years to low-marginal-tax-rate years (e.g., by spending more from tax-deferred accounts or doing Roth conversions in a given year in order to increase taxable income in that year and reduce it in future years).
  5. Repeat steps 3 and 4 until a) your marginal tax rate is projected to be fairly steady going forward (such that you would not benefit from further shifting income from one year to another) or b) you are out of options for income-shifting.

So, for example, in the case of our reader above, his marginal tax rate will likely be at its lowest point in the years after his wife retires and before they start receiving Social Security. So it would likely be advantageous to increase taxable income in those low-tax-rate years (by spending from tax-deferred accounts and likely doing Roth conversions) in order to reduce taxable income in laters years in which they would otherwise have a higher marginal tax rate.

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