Roth conversions are, in essence, a way to pay income taxes on pre-tax retirement funds in exchange for future tax-free growth and withdrawals. The decision of whether or not to convert pre-tax assets to Roth is, on its surface, a simple one: If the assets in question would be taxed at a lower rate by converting them to Roth and paying tax on them today, versus waiting to pay the tax in the future when they are eventually withdrawn, then the Roth conversion makes sense. Conversely, if the opposite is true and the converted funds would be taxed at a lower rate upon withdrawal in the future, then it makes more sense not to convert.
But what exactly is the tax rate that should be used to perform this analysis? It’s common to look at an individual’s current level of taxable income, determine which Federal and/or state income tax bracket they fall under based on that income, and assume that would be the rate at which the individual will be taxed on any funds they convert to Roth (or the amount of tax savings they would realize in the future by reducing the amount of their pre-tax withdrawals).
However, for many individuals, the tax bracket alone doesn’t accurately reflect the real impact of the Roth conversion. Because of the structure of the tax code, there are often ‘add-on’ effects created by adding or subtracting income – and these effects aren’t accounted for when simply looking at one’s tax bracket.
For example, when an individual is receiving Social Security benefits, adding income in the form of a Roth conversion could increase the amount of Social Security benefits that are taxed so that the increase in taxable income caused by the Roth conversion is more than ‘just’ the amount of funds converted – in effect, the increase in income can magnify the tax impact of the conversion beyond what the tax bracket alone would imply. However, the same effects are also true on the ‘other’ end of the Roth conversion, where any reduction in tax caused by replacing pre-tax withdrawals with tax-free Roth withdrawals could also be magnified by an accompanying decrease in the taxability of Social Security benefits.
The upshot is that the conventional wisdom of deciding whether (or how much) to convert to Roth based on tax brackets alone won’t always lead to a well-informed decision. Instead, finding the ‘true’ marginal rate of the conversion (i.e., the increase or decrease in tax that is solely attributable to the conversion itself) is the only way to fully account for its impact. Additionally, understanding the true marginal rate can make it possible to time conversions in order to minimize the negative add-on effects (e.g., avoiding Roth conversions when doing so will also increase the taxation of Social Security benefits) and maximize the positive effects (e.g., using funds converted to Roth to reduce pre-tax withdrawals when doing so will decrease the taxation of Social Security) – thus maximizing the overall value of the decision to convert assets to Roth.