How to Determine if a Roth Conversion Will Help Your Tax Bill in Retirement
Even under the most conventional circumstances, American taxpayers struggle to fully understand the myriad of tax-advantaged retirement investment options available. Each has slightly different tax implications and a separate set of complex compliance rules, contribution limits, mandatory withdrawal requirements and other features.
In this article, we guide U.S. expats to compliant and efficient use of IRAs and Roth IRAs, specifically addressing the potential advantage of Roth conversion and broader overseas U.S. citizen tax strategies.
For the sake of simplification, this discussion assumes all traditional IRA contributions are pre-tax contributions only. U.S. state and local tax rates are not factored in here. If you’d like to learn more about how state and local taxes factor into the decision of whether to conduct a Roth conversion, read this article.
A Brief Refresher on How Roth IRAs Work
Roth IRAs work in a reverse manner to the traditional IRA. Contributions to a Roth IRA generate no immediate tax savings. However, when distributions of both principal and investment earnings are taken in retirement, they are tax exempt. Contribution limits for Roth IRAs are the same as those for regular IRAs.
Unlike traditional IRAs, single filers with a modified adjusted gross income (MAGI) above $153,000 and those married filing jointly with MAGI above $228,000 cannot make annual Roth contributions.
Roth Contribution Limits for 2023
| If your 2023 filing status is… | And your MAGI is… | Then you can contribute… |
|---|---|---|
| Married filing jointly or qualifying widow(er) | < $218,000 | up to the limit |
| > $218,000 but < $218,000 | a reduced amount | |
| > $228,000 | zero | |
| Married filing separately and you lived with your spouse at any time during the year | < $10,000 | a reduced amount |
| > $10,000 | zero | |
| Single, head of household, or married filing separately and you did not live with your spouse at any time during the year | < $138,000 | up to the limit |
| > $138,000 but < $153,000 | a reduced amount | |
| > $153,000 | zero |
Roth IRA Conversion: How it Works
There’s an option to convert an existing traditional IRA (as well as other tax-deferred retirement plans) to a Roth IRA. All or part of the traditional IRA can be converted. Conversion is available for all traditional IRA accounts without respect to income. Conversion, however, requires the account holder to report the full value of the amount converted as regular income in the year converted.
An important advantage of the Roth IRA is that it has no minimum distribution requirement during the account owner’s lifetime. Meaning, the entire balance of the account can simply be left to grow free of tax, and then be bequeathed to estate beneficiaries. However, since the 10-year beneficiary rule passed in 2019 (SECURE Act), beneficiaries of an inherited IRA (including Roth IRAs) must withdraw the entire balance of the IRA by December 31 of the year containing the 10th anniversary of the owner’s death.
Learn more about the advantages and disadvantages of expat Roth conversions, and effective strategies how they can be used while living abroad.
Special Expat Roth IRA Considerations
Many American expats who have married non-Americans elect to file married but separately. Read more on the special planning considerations for mixed-nationality couples. Taxpayers with this filing status are generally not allowed to make any IRA contributions. Roth conversions are still permitted.
As previously noted, conversion of a traditional IRA to a Roth IRA requires the account holder to report all the amount converted as regular income in the year of the conversion. That may result in a very large tax bill due for individuals at the time of conversion, depending on the size of the amount converted, so it’s important to carefully analyze the tax consequences of Roth conversion.
The choice between a Roth or traditional IRA is a choice between taxation at current tax rates or at future tax rates (in retirement). Generally, it’s better to defer taxes (and collect investment return on the amount of taxes deferred) than to pay now. This is especially true when future tax rates will be lower than current tax rates.
Roth IRAs: When to Contribute vs. Convert?
However, the Roth also allows all future appreciation to be totally tax-free. The value of tax-free growth may more than offset the negative impact of paying now at higher rates. Therefore, the calculation of whether it makes financial sense to contribute to a Roth IRA or convert a traditional IRA to a Roth IRA largely depends on two variables:
- The marginal tax rate at which taxes will have to be paid on amounts converted or contributed now
- The marginal tax rate prevailing at the time money is withdrawn from the traditional IRA, if conversion is not carried out
Analysis shows that when retirement tax rates are expected to be the same or higher than current rates, Roth contributions and Roth conversion are unambiguously the right choice. When marginal tax rates in retirement are expected to be substantially lower than current marginal tax rates, the traditional IRA proves optimal.
How to Judge Current and Future Tax Rates
Determining current and future tax rates is a complex exercise. First, future tax rates are uncertain. Second, good financial planning can help reduce tax rates now and in the future, which in turn will alter the pay-off of employing a Roth. Within this context, the value of Roth conversion will be determined by:
1. Proper calculation of the current marginal tax rate
Marginal tax rate refers to the rate at which your last dollar of taxable income is taxed. This can range from 10% for individuals with less than $11,000 of taxable income to 37% for individuals with taxable income of more than $578,125 in 2023. Taxpayers considering a Roth conversion must be aware that conversion may raise the marginal tax rate at which at least some of the converted amount is taxed.
For example, an individual with taxable income of $110,000 in 2023 falls into the 24% marginal tax bracket. If he or she has a $100,000 traditional IRA to convert and converts all of it in 2023, the effect of the additional income will push him of her into the 32% marginal tax bracket, causing part of the converted amount to be taxed at the 32% rate and part at the 24% rate.
In such cases, it may be optimal to spread the conversion out over several years so that the conversion itself does not push the taxpayer into a higher tax bracket. Careful analysis of an investor’s tax situation is required.
2. A changing year-to-year financial and tax situation
Individuals who experience large swings in their annual income may be most able to benefit from Roth. For example, consider a taxpayer with $100,000 in a traditional IRA account who experienced a period of unemployment during 2023 and, as a result, has little or no income for the year. The taxpayer finds new, high-paying work for 2024 and, in general, is likely to be well-off in retirement.
This is an ideal situation for Roth conversion. Most of the $100,000 in the traditional IRA can be converted at a relatively low tax rate in 2023. This can result in a large tax savings. In such a scenario, it may be optimal to contribute and/or convert, even if the investor ends up in a relatively low marginal rate during retirement.
3. Estimating retirement year tax rates
Deriving a realistic estimate of marginal tax rates twenty to thirty years in the future requires a lot of careful financial planning and some educated guesswork. Taxpayers must analyze and estimate likely sources of retirement income (social security, pensions, investment income, etc.).
Consideration of the national economic and financial environment must also be factored in: most analysts expect tax rates to rise over the medium to long term in the United States, although this is not by any means a foregone conclusion.
Important Expat Roth Conversion Considerations
Expats have to go through the same process of estimating current versus future marginal tax rates, but deriving accurate rate estimates requires considering several additional factors, such as:
1. State taxes
State taxes are an important part of the Roth conversion calculation for Americans abroad. In many cases (but not all), Americans living abroad are not subject to state taxation. If they intend to return home and retire in a state that taxes traditional IRA distributions (as most states do), the ability to convert without paying state taxes on the conversion (and thereby permanently removing the assets from both state and federal taxes) effectively lowers the bar in favor of conversion.
2. Host country taxation
If the Roth IRA conversion amount is subject to local taxation at a higher rate than the applicable U.S. rate, it may be better to forego Roth conversion or defer it until returning to the U.S. (if a return is anticipated). Furthermore, most countries may not recognize Roth IRA distributions as tax-exempt. The taxpayer thereby risks being double taxed, a common expat investing mistake: once on the amount contributed when it was earned and again when it’s distributed in retirement.
3. How long you plan to live abroad
Americans who anticipate living abroad permanently may want to consider a host of unique planning opportunities to reduce their retirement marginal tax rate. For example, consider the case of an American citizen living in Hong Kong and married to a Hong Kong citizen who is not an American citizen or U.S. permanent resident (also known as a non-resident spouse). Suppose the American citizen has large amounts of unrealized capital gains in an investment portfolio and anticipates selling those holdings to fund retirement.
In that case, the American citizen should consider annual gifts of stock to his or her Hong Kong spouse (in 2023, an American citizen can gift up to $175,000 per year to a non-U.S. citizen spouse without paying gift tax). The spouse, in turn, can sell the stock and pay no capital gains, as Hong Kong does not have a capital gains tax. When properly employed, such a strategy of gifting appreciated assets to a non-resident spouse may reduce the American citizen’s retirement tax rate to a level well below his or her tax rate at the time the conversion decision had to be made.
The complexities of living abroad are numerous and too specific to each individual case to completely list here. Suffice it to say, the Roth conversion decision requires careful consideration, and required analysis is further complicated by additional financial planning factors unique to Americans abroad. You can learn more by watching “4 Questions for U.S. Expats Investing in IRAs and Roth IRAs” on our YouTube channel.
Tax Diversification Among IRA Accounts
For many younger taxpayers, or the merely moderately well-off, making a close to definitive conclusion about whether conversion is financially optimal may not be possible. There can be too many uncertainties about retirement year financial circumstances for an accurate calculation to be made. This is one of the reasons taxpayers may want to pursue a strategy of tax diversification.
In this scenario, the taxpayer contributes some annual amounts to a Roth and some to a traditional IRA. Likewise, part of an existing traditional IRA is converted, and part is not. This approach effectively hedges the taxpayer against the risk of being in a much higher or lower marginal tax environment during retirement than they anticipated when they made the decision between a traditional and Roth IRA.
How Expats Can Employ Tax Diversification Across IRA Accounts
Tax diversification makes especially good sense for Americans abroad, because the complexity of the conversion calculation is augmented by their special tax and planning circumstances. The more complicated the calculation, the higher the risk that the wrong decision will be made, and, therefore, the greater the benefit of a hedged approach, as offered by the tax diversification strategy.
Although specific analysis of each situation is required, most wealthy Americans will find that Roth contributions and strategically executed Roth conversions make sense. For taxpayers not expecting to be in the higher tax brackets during retirement, the decision is not clear-cut.
For many moderately financially well-off Americans, a Roth may ultimately generate a very large tax savings, but changing personal financial circumstances changes and changes in future tax policies (both in the U.S. and/or in the country of residence) could cause this not to be the case.
Factors uniquely affecting Americans abroad will have a broad impact on the calculation. As always, it’s best to consult with a qualified investment advisor or tax consultant before making a final decision. Creative Planning International can help. Request a meeting with an international wealth manager today to learn how you can take advantage of Roth conversion to potentially lower your retirement tax bill.
