Analysis of Break-Even Tax Rate for Roth Conversions

Introduction

A common rule of thumb is that a Roth conversion is attractive when the expected tax rate in retirement is higher than the tax rate paid on the Roth conversion. This rule is directionally correct. But it is also a weak condition. As will be seen below, the expected tax rate in retirement can afford be lower if the tax on the conversion is paid from a taxable account. (This effectively redirects assets from an inefficient taxable account into a tax efficient Roth account.) 

This post derives, under a simplified set of assumptions, the required tax rate in retirement that makes the Roth conversion beneficial for an after-tax retirement spending scenario. (Vanguard has termed this the Break-Even Tax Rate or BETR.) Below this rate, the modeled Roth conversion produces less after-tax spendable wealth compared to leaving the money in the Traditional IRA.

The comparison is between the following two strategies:

• Default strategy: No Roth conversion. No conversion tax to pay. Hence, no withdrawals from any taxable account to pay conversion tax.
• Roth conversion strategy: An amount $P_0$ is converted from the Traditional IRA (T-IRA) to Roth IRA (R-IRA). Separately, an amount $W_0$ is consumed from a taxable account to pay conversion tax.

Both comparisons are designed to start with the same total wealth ($P_0$ in the T-IRA, $W_0$ in the taxable account). The growth of $W_0$ within the taxable account in the default strategy represents the opportunity cost of paying the conversion tax.

Redirecting Taxable investments to Roth 401(k) - An Improved Analysis

This is a follow-up to Redirecting Taxable investments to Roth 401(k). The analysis is conducted in terms of capital appreciation and dividend yield rates. It also incorporates the additional basis created in a taxable account by dividend reinvestment.

Redirecting Taxable investments to Roth 401(k)

Preface

This article is for those in the USA who

• have access to after-tax 401(k) contributions with immediate in-plan conversion to Roth 401(k), aka, Mega Back Door Roth (MBDR), and
• have a taxable brokerage account with sufficient assets that can be leveraged to facilitate the MBDR.

Introduction

Usually, people focussed on saving and investing set their retirement contributions so that their net pay covers living expenses. Assuming one is already maxing out contributions to tax-advantaged retirement accounts and has accumulated a nontrivial amount of investments in a taxable brokerage, the question naturally arises:

Does it make financial sense to take advantage of the MBDR even if it means that one has to draw down on the taxable brokerage to fund living expenses?