Roth Conversions; the Economic Hurdle – Part 2 of 4
“The social responsibility of business is to increase its profits.”
— Milton Friedman
Just about every business has two objectives: first survival, then growth, achieved through the optimal and effective deployment of both current and future resources. When viewed through this lens, the same principle applies to your personal financial life. You are, in effect, running a personal enterprise. Its objective should be to maximize marginal utility, or happiness, through the most disciplined and intentional use of your present and future wealth.
This is accomplished through controlled spending, prudent investment management, tax efficiency, and thoughtful estate planning. In this follow-up essay to Roth, No Free Lunch (Part 1 of 4), I will briefly examine the viability of Roth conversions, specifically through the lens of break-even analysis.
A break-even point is the moment when the cumulative cost of one decision equals the cumulative cost of the alternative. In the context of Roth conversions, the break-even age is the point at which the total cumulative taxes paid upfront to convert a Traditional IRA to a Roth equals the cumulative taxes that would have been paid had the conversion not occurred. Beyond that point, the Roth conversion begins to generate a net economic benefit.
The following graph for an age 62 client, generated using Income Lab’s financial planning software, helps to illustrate this concept:
Each line in the graph reflects separate strategies for paying taxes on pretax retirement assets such as a Traditional IRA or 401(k). The blue line represents cumulative taxes paid through proactive Roth conversions, accelerating taxes today to reduce future liability. The yellow line represents cumulative taxes paid by leaving assets in the pretax account and deferring taxation until distributions occur. Where the lines intersect marks the break-even age, after which the Roth conversion strategy begins to produce a net tax advantage.
The steeper blue line reflects the front loading of taxes through Roth conversions, with the perceived benefit, adjusted for inflation, not appearing until the lines intersect around 2050, when cumulative taxes under both strategies are equal. For this retired client, that break even occurs at age 86, meaning the economic advantage begins very late in life. After testing more than a dozen scenarios for individuals in their early to mid 60s using Income Lab’s software, the cumulative break even consistently landed in the mid and in some cases late 80s.
Summary:
Roth conversions are often presented as an obvious, sometimes guaranteed, upgrade, but when viewed through a break even lens the economic hurdle becomes clear. For many retirees in their early to mid 60s, modeling shows the tax advantage does not emerge until the mid to late 80s, which requires meaningful longevity simply to justify the upfront tax cost. In other words, a Roth conversion is a bet that time, growth, and lifespan work in your favor, and the math alone should give pause. In the next essay I will move beyond the numbers and examine some broader risks and structural uncertainties that can further undermine the expected benefit of conversions and make the decision far less certain than it is often portrayed.
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Brett F. Anderson, CFP® CIMA® CAIA® M.S. Econ
Do you have questions? I'd like to help. Please call me at (864) 790-3385.
Past performance is no guarantee of future returns;
this is NOT investment advice and is meant to be educational.
Please consult a qualified tax advisor before making any decisions.