Recent changes to IRAs have led a professor emeritus at Santa Clara University to call for adjusting the established thinking regarding Roth IRAs.

Specifically, Edward F. McQuarrie posits that tax rates need not be higher in the future to make conversion beneficial, outside funds may not be needed to cover the tax cost of the conversion and the benefits of conversions help those who make part of the conversion in a 0% tax bracket instead of the highest tax bracket.

The IRA changes that have inspired McQuarrie’s new thinking on conversions include the postponement of when required minimum distributions (RMDs) must start, the revised RMD divisor tables and the ending of stretch IRAs.

According to McQuarrie’s paper, the payoffs from conversion “are often small and slow to arrive,” but a conversion “will almost always pay off if given enough time.” Retirees who live past age 90 and do not take distributions from the converted amounts are most likely to realize the benefits of a conversion. The payoff is often modest, but the magnitude of the benefit increases with age.

Future tax hikes—often touted as a reason for conversion—were found to confer an unexpectedly small benefit. Roth conversions fared better when future tax rates were assumed to increase, but not by much. However, if an investor or their financial adviser guessed wrong, and future rates were cut moderately rather than hiked, Roth conversions still paid off in almost every case.

The key to realizing success from a Roth conversion is allowing the converted amounts to benefit from compounding. It may take decades, but faster compounding always overcomes the initial tax cost.

Investors considering a Roth IRA conversion are encouraged to ask a few key questions. First, are they on track to accumulate surplus funds in their tax-deferred account? Second, do they have the patience to wait until after age 90 to see the payoff from doing the conversion? Finally, is it possible to make at least part of the conversion in the 0% bracket? Negative answers to all three should prompt a look at alternatives (a backdoor Roth IRA, life insurance products, etc.). Those able to answer yes to the third question may be best positioned to benefit from doing a conversion.

Source: “When and for Whom Are Roth Conversions Most Beneficial? A New Set of Guidelines, Cautions and Caveats,” Edward F. McQuarrie; SSRN, June 2021.

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