It’s hard to hand over a big portion of your retirement savings when you’re old or getting there. Every fiber in your being shrieks “mistake.” And sometimes it is a mistake, as it was for Bob and Sandy Curtis, who forked out $840,000 in entrance fees for a continuing care retirement community that subsequently filed for bankruptcy.
Other times, though, writing a very big check is exactly the right thing to do for your long-term financial health. I’m referring to “Rothification,” a maneuver that costs a lot in taxes up front but raises your potential living standard in the long run. I wrote about it last year.
Rothification is the conversion of an ordinary individual retirement account or 401(k) into a Roth I.R.A. For simplicity I’ll stick with the case of converting an ordinary I.R.A. to a Roth I.R.A. from here on.
In an ordinary I.R.A., you put in money that hasn’t been taxed yet. (You can also put in money that has been taxed, but I’m going to ignore that complication.) Money in the I.R.A. grows tax-deferred. Later, when you withdraw money from the I.R.A. to cover retirement expenses, you pay taxes on the withdrawals as ordinary income. An ordinary I.R.A. can be a good deal if you expect to be in a lower tax bracket in retirement than during your working years — say, because you won’t have a lot of retirement savings to draw upon.
A Roth I.R.A., the mirror image, is stuffed with money that’s already been taxed. The money grows tax-free, and when you withdraw from it, you don’t have to pay any taxes on either the original contribution or any subsequent gains. It’s a great deal if your tax bracket in retirement is as high or higher than it was during your working years, as happens more often than many people expect. It can sometimes be a good bet even if you’re in a lower tax bracket in retirement: Because the withdrawals don’t count toward your taxable income, they help you avoid many years of income-related taxes on Social Security, lower your Medicare premiums and limit required minimum distributions from your ordinary 401(k) or I.R.A., which are taxed.
Now, back to writing that big check. The pain of a Roth conversion comes when the government demands its cut up front. The money you take out of an ordinary I.R.A. to fund the Roth I.R.A. looks like regular income to the Internal Revenue Service and is taxed as such. The maneuver may push you into a higher tax bracket — say from 22 percent to 24 percent, 32 percent, or even 35 percent.
Ouch. In financial planning, conventional wisdom says you should usually put off paying taxes as long as possible, and that you should even out your annual income so there’s never a year when you get pushed into a higher tax bracket. That would sometimes suggest stretching out a conversion to a Roth over many years or not doing it at all. That’s the answer you might get from a free online calculator, of which there are many.
In reality, though, the best move for a lot of people is to take the tax hit and convert a lot of money quickly, says Laurence Kotlikoff, an economics professor at Boston University. “Go big or go home may be your best strategy,” he wrote in his newsletter Economic Matters in November.
Kotlikoff, whom I have quoted frequently, has a company, Economic Security Planning, whose software tool, MaxiFi Planner, uses economic principles rather than financial planning rules of thumb to help clients make decisions on Roth conversions, when to claim Social Security, how much life insurance to carry and other questions with big financial ramifications.
(MaxiFi is legit, by the way. Robert Merton, who has a Nobel for his work on derivatives, including the Black-Scholes-Merton options pricing formula, wrote in an email that he uses MaxiFi software in the asset management course he teaches at M.I.T.’s Sloan School of Management.)
Kotlikoff gives an example of a 65-year-old single retiree in Tennessee named John with $1.25 million in regular assets and an equal amount in an ordinary I.R.A. By converting about $1.1 million in his ordinary I.R.A. to a Roth I.R.A. over five years, John saves money on federal income taxes and extra Medicare premiums that are tied to income, allowing him to spend about $2,600 more per year through age 70 and about $11,600 more per year after that, according to MaxiFi’s calculations. John makes out even better if he also postpones claiming Social Security until age 70.
The hurdle for John is that the tax bill over the five years that he’s converting is nearly $300,000, versus a status quo tax bill of about $18,000. Many people are understandably hesitant to part with such a big sum, Rick Miller, a financial planner at Sensible Financial Planning and Management in Waltham, Mass., who uses Kotlikoff’s MaxiFi software with clients, told me.
“I can’t just tell a client, ‘MaxiFi says,’” Miller told me. “I have to walk them through the logic of why it comes up with that answer. It takes a lot of looking and thinking to figure out where that comes from. I have to look year by year at the outputs.”
Joel Dickson, the global head of enterprise advice methodology at Vanguard, the big investment manager, told me that he agrees with Kotlikoff’s “go big” advice for many people, and has been saying the same thing himself for years.
The financial-planning platform Boldin, formerly NewRetirement, ran numbers on its clients and found that the median client could save about $150,000 by converting to a Roth, Steve Chen, the founder and chief executive, told me.
Everybody’s circumstances are different, of course, and accountants and lawyers need to be in on the decision. Don’t rely entirely on the output of free online calculators, which don’t take in enough data about you to be precise and may not use the most sophisticated calculation techniques.
I’m going to take off my personal finance hat now and say that I’m not a big fan of Roth conversions from the standpoint of public policy. They’re a back door that lets well-to-do people take advantage of a saving vehicle that was originally intended to help the working and middle classes prepare for retirement. Reflecting the original intent, the cap on the contribution to a Roth I.R.A. in 2025 is $7,000, or $8,000 for someone 50 and over, and joint filers’ modified adjusted gross income must be under $236,000 to make a full Roth I.R.A. contribution.
Those rules have lost their power because there’s no limit on who can do a Roth I.R.A. conversion, or how much they can convert. A conversion used to be restricted to people with adjusted gross income under $100,000 to stop higher-income folks from indirectly funding Roth I.R.A.s, but that limit ended in 2010.
Some pretty rich people have caught on that Roth I.R.A.s aren’t just for retirement. ProPublica, an investigative journalism organization, reported in 2021 that the venture capitalist Peter Thiel had $5 billion in his, and had used it as an active investment vehicle.
Last year, President Joe Biden proposed, to “ensure that the ultrawealthy cannot use these incentives to amass tax-free fortunes,” a measure that, according to the Department of Treasury, would generate nearly $24 billion in extra tax revenue over 10 years. It didn’t get anywhere, but it’s the kind of thing the Trump administration should be looking at as a way to shrink budget deficits.
So from the public policy standpoint, too many people are doing Roth conversions. From a personal finance standpoint, though, too few are. If you’re not one of those rare people who make gifts to the federal government (link here), then as long as the laws remain as they are, you should probably look into whether Rothification is right for you.
The Readers Write
You wrote about why common problems are often worse than we realize. Climate change strikes me as a perfect example of a colossal problem that is denied. Is it the lack of immediacy, the elusiveness (to some) of its cause and effect or the overwhelming size of the problem and the considerable sacrifice required to address it that causes us to sweep this existential problem under the rug?
Greg Comeaux
Thousand Oaks, Calif.
As for the argument that President Trump’s greatest resistance could come from Wall Street: The policies of the current administration are inflationary, and the Federal Reserve chair, Jerome Powell, will be blamed (unjustly). However, if we have increased inflation, the Republicans will lose the congressional elections in two years.
John Dunn
New Canaan, Conn.
The writer is an economics professor at the University of Connecticut.
Thanks for the reminder that there still may be other checks and balances on this guy. At least one can hope!
Troy Gamble
Robbinsdale, Minn.
Quote of the Day
“Civilization hangs suspended, from generation to generation, by the gossamer strand of memory. If only one cohort of mothers and fathers fails to convey to its children what it has learned from its parents, then the great chain of learning and wisdom snaps.”
— Jacob Neusner in Chronicles: A Magazine of American Culture (Sept. 1, 1991)
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