Ins and Outs of Roth Conversions

As we all tend to do with complex issues, you may find yourself seeking simple rules to determine whether to convert your traditional IRA or 401(k) to a Roth account. A conventional answer you might find near the top of a Google search is to convert if your expected future tax bracket is higher than your current one. That decision making rule is overly simplistic because there are other individual circumstances that affect the favorability of conversion. I recommend studying relevant details pertaining to your particular situation. As a starting point, in this article I’ll discuss some helpful research on the topic.

Professor Edward MacQuarrie weighs the present value (PV) of a lump sum current tax hit against the PV of a series of future tax savings, recasting the conversion decision into a net present value (NPV) one[1]. By discounting future tax savings to reflect the time value of money, his approach creates a fair apples-to-apples NPV analysis.

MacQuarrie begins by explaining a common money illusion that may occur when conversions do not apply a discount rate to future tax savings. He argues persuasively for using the expected return on the tax-deferred portfolio as the appropriate discount rate in the PV calculation, “Suppose a $10,000 portfolio in a tax-deferred account is invested in stocks returning 10% and that the tax rate on withdrawals is 25%. If the account is converted today, tax of $2,500 will be due. If the account is liquidated after one year of appreciation, $11,000 will be withdrawn, and the tax due will be $2,750. Discounted at the portfolio rate of appreciation, paying $2,750 after one year is no different from paying $2,500 today …. If any lower rate of discount were to be applied to future tax savings (whether inflation, the risk-free rate, or no discount at all), then Roth conversions would always pay off spectacularly if held for long enough. Left in stocks for 30 years, that $10,000 portfolio has an expected future value of about $175,000; undiscounted, the future tax savings would be about $43,625. Absent any discounting, a rational taxpayer would always convert immediately, paying only $2,500 in tax today to save tens of thousands of dollars in future tax.”

Unfortunately, financial planning software may lead advisors and their clients into the trap MacQuarrie describes. For example, I entered various Roth conversion scenarios into a financial planning system. The scenario comparisons highlight the difference in total taxes paid over the entire plan duration by totaling undiscounted future tax savings. They simplistically state “Proposed strategy results in … $X less taxes paid” and “… $Y more tax adjusted ending assets”. In fairness, the system is robust in the sense that it also provides forecasts of the breakeven period in total assets, when the positive effect of compounded tax-free growth overtakes the negative effect of near-term withdrawals to pay income tax. But advisors have to seek that information and may not present it to clients. If the only thing you hear reported from a financial advisor is something like , “My proposed strategy will save you $X in taxes…”, you should ask a lot of probing questions about the timing of the savings and when will you breakeven under the scenario(s) modelled by the advisor.

A scenario I modelled was a 2-year Roth conversion program for a retired couple in their early 60’s who may be in a lower tax bracket for the next several years than they expect to be in the future. They plan to claim Social Security retirement benefits no sooner than their full retirement age of 67. The undiscounted scenario modelled in financial planning software showed savings in lifetime federal taxes of over $338,000. However, when I discounted the predicted tax savings at 8% (an estimated return on their tax-deferred accounts), the predicted tax savings disappear! Rather than resulting in significant forecasted lifetime tax savings, the same scenario shows a lifetime tax cost of about $900 in present value terms. You read that right - on a discounted basis the conversion scenario shows higher lifetime taxes because the future tax savings are relatively small in present value terms.

Now, as much as we owe a debt of gratitude to Professor MacQuarrie for pointing out how easily Roth conversions can be oversold, that is not the end of the story. A conversion decision is part of an intricate jigsaw puzzle unique to every household. When combined with other variables such as asset location, the account type used to pay the tax due upon conversion, time horizon, and financial goals including bequest aspirations, the impact of a conversion may still be positive even if the result from MacQuarrie’s analysis is unfavorable.

To isolate the effect of implementing a tax sensitive asset location strategy, for example, I went back to my financial planning software and specified an order of preference for where to hold equities. I used a 50/50 asset allocation and expressed an order of preference to first hold stocks in tax free accounts like a Roth IRA, then taxable accounts, followed by tax deferred accounts like a traditional IRA or 401(k). I compared this against a pro rata strategy where the same 50/50 allocation is held proportionally in all accounts regardless of account type. I did not make any Roth conversions in either scenario. The withdrawal sequence for both is to spend first from taxable accounts, then to spend from tax deferred accounts, followed by tax free accounts. The asset location strategy resulted in undiscounted tax savings in excess of $219,000 over the life of the plan. Because there is no tax outlay required to implement the strategy, on an NPV basis this savings equates to almost $36,000 of present value creation. Apparently, diversification is not the only free lunch!

The analysis demonstrates that the asset location decision interacts with the Roth conversion decision. For example, if someone did not have a tax free account to hold equities, it might pay to do a Roth conversion even if it is not very favorable on a standalone basis in MacQuarrie’s NPV terms. By putting your high growth assets into a tax free account, you remove tax drag from the best performing investments thereby enhancing long term wealth creation.

To study the interaction effects of asset location and other variables on Roth conversion decisions, I found a Vanguard research paper[2] that is helpful. The paper presents a method for finding what “… future tax rate would make an investor indifferent to a conversion.” In other words, the authors (Boris and Dickson) find a BreakEven Tax Rate (“BETR”) that essentially reconceptualizes the discount rate used by MacQuarrie. This rate incorporates differences in expected returns between account types that would follow implementation of an asset location strategy as well as other variables such as the tax drag of the account used to pay income tax due upon conversion. Vanguard’s Boris and Dickson build on an approach used in Kitces (2009), “which computed a breakeven future tax rate for a few scenarios…”. Their metric, BETR, “shows how far your tax rate would have to fall to make conversion undesirable”.

To begin, paying conversion taxes from a taxable account creates an advantage in favor of conversion, which can still be beneficial even if your future tax rate is somewhat lower than your current one. In Appendix A of their paper, Boris and Dickson show how BETR is determined when you pay conversion taxes from a taxable account. The illustration assumes conversion of a $10,000 traditional IRA to a Roth IRA with a 6% annual expected return over 20 years. The steps to derive BETR are:

1.  Determine the expected gross future value of conversion over a specified time period. In the example, the $10,000 moves to a Roth IRA which earns 6% annually for 20 years:

2. Determine the opportunity cost of conversion, which equals the growth you would have earned on the money used to pay conversion tax. Assuming  a tax drag at the same marginal income tax rate of 35% and the same 6% before tax return, we have:

3. Subtract the opportunity cost of conversion from the expected gross future value of conversion. This is the net future value of the conversion scenario:

4. Express the unknown future value of the no-conversion scenario. If we do not convert, the $10,000 remains invested in our tax-deferred traditional IRA account, growing at 6% per year for 20 years. Then the entire balance is taxed at the future tax rate, tFuture, which is unknown:

5. Solve for the tax rate at which you would be indifferent to conversion, the BETR, by  setting the unknown future value of the tax deferred account (the no-conversion scenario) equal to the known net future value of the tax free account (the conversion scenario):

This analysis shows that the appropriate hurdle for the future tax rate, in order for a Roth conversion to be favorable, is not the current marginal rate of 35%, but the BETR of 23.5%. As long as your future rate is higher than BETR, doing the Roth conversion will create wealth.

Note that different assumed rates of return can be used for expected growth in different accounts to facilitate asset location strategies and other variables like tax drag. This is because the final BETR determination is calculated from a simple ratio of future account values representing the no-conversion and conversion scenarios. The underlying assumptions driving how you arrive at those future values are entirely flexible. One of the examples Boris and Dickson provide shows that the more tax inefficient the taxable account is from which you pay the tax, the lower BETR becomes.

A key contribution of BETR is that it compares future values against future values rather than creating a money illusion by comparing future values with present values. Another is BETR’s flexibility. Other variables can readily be taken into account using the BETR approach, including time horizon, the tax basis for IRAs with after tax contributions, and future Roth backdoor contributions.

We all have to grapple with the inherent uncertainty of the future. BETR cannot help us  predict what will happen, but it does provide a robust framework which empowers investors to observe a range of tradeoffs as they make Roth conversion decisions that interact with other aspects of their financial picture. I find one of the most persuasive arguments in favor of Roth conversions to be the simple goal of diversifying across tax treatments. That is the only way to manage future tax liabilities on a year-to-year basis. Even if your future tax rate turns out to be lower than you predict, tax risk is taken off the table when you have Roth treatment – which is why having at least a chunk of your portfolio in Roth accounts makes sense in the first place. The hard questions are how much and when to convert. Doing BETR analysis helps with these choices based on your unique financial goals and circumstances.

[1] MacQuarrie, Edward F. “Net Present Value of Roth Conversions”, Journal of Financial Planning, September 2024.

[2] Wong, Boris C., Dickson, Joel M. “A ‘BETR’ Approach to Roth Conversions”, Vanguard Financial Planning Perspectives, August 2022.

© 2025 Philip Murphy. All rights reserved. The information presented herein is the opinion of the author and does not reflect the views of any other person or entity unless specified. The information provided is believed to be reliable and obtained from reliable sources, but no liability is accepted for inaccuracies. The information provided is for informational purposes and should not be construed as advice. Advisory services offered through IndiePlan™ LLC, an investment adviser registered with the state of New York.