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Most investors approach Roth conversions with a simple question: Will my future tax bracket be higher than my current one?
On paper, that seems like the most important question. A Roth conversion means taking a tax hit today to avoid one later, so if you expect to be in a lower tax bracket in retirement, the strategy is less appealing. If pensions and required minimum distributions are likely to push you into a high tax bracket in retirement, the conversion makes much more sense.
However, an analysis from Vanguard suggests that this approach is incomplete because it doesn’t consider several other factors that should determine whether a Roth conversion is a good idea for your specific situation (1).
To solve this problem, the financial giant offers a more precise model to evaluate Roth conversions: the breakeven tax rate, or BETR. But what exactly is the BETR approach, and can it really benefit you?
Here’s a closer look at the BETR approach and how it could help you make the right moves for your retirement.
According to Vanguard, the BETR is the future tax rate at which it makes no difference whether you convert or not. In other words, it is the tax rate where the outcome is the same either way.
This breakeven rate is calculated based on your assumptions about portfolio growth. For example, if you assume the assets in a traditional IRA will grow at 6% a year, any taxes you pay today represent money that no longer gets the chance to compound at that rate over time.
By accounting for this opportunity cost, BETR offers the precise tax rate at which a conversion neither helps nor hurts you. If your future tax rate ends up higher than the BETR, a Roth conversion saves money. If it’s below, vice versa.
Here’s an example that helps bring this principle to life.
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Vanguard uses the case of Jill, a high-income investor with $100,000 in a traditional IRA. She expects the account to triple to $300,000 over 20 years. Her current marginal tax bracket is 35%, and she expects it to fall to 24% in retirement.
Using the traditional approach, a Roth conversion looks attractive. After all, her future tax rate is lower than her current one.
The BETR calculator lays out two possible scenarios — one where she converts it, one where she doesn’t — to dig deeper:
Conversion: Jill converts the $100,000 to a Roth IRA and pays a 35% tax, or $35,000. Vanguard assumes this tax bill is paid in cash and that the cash would have doubled in 20 years if left invested. That lost growth, roughly $70,000, has to be subtracted from the Roth’s final value. The result is an after-tax balance of $230,000.
Non-conversion: Jill leaves the money in her traditional IRA, allowing it to grow to $300,000. When she withdraws the funds in retirement, she pays a 24% tax, or $72,000. Her after-tax balance is therefore $228,000.
Vanguard calculates that Jill’s BETR is 23.3%. Since her expected retirement tax rate is slightly higher (24%) than that, the Roth conversion does make sense, but only marginally. The difference between converting and not converting is just $2,000.
If this math feels complex, the good news is that Vanguard offers an online calculator that can help you estimate your own breakeven tax rate (2).
Even if you can do the math on your own, most would-be retirees want to run several scenarios for their futures, depending on how well their portfolios perform and their anticipated lifestyle needs in retirement.
To do this effectively, you may want to work with a financial advisor, who can explore several likely outcomes and help you make the most informed decisions about your IRA withdrawals and more.
Finding the right advisor is simple with Advisor.com. Their platform connects you with licensed financial professionals in your area who can provide personalized guidance.
A professional advisor can also help you determine how many years you have left to invest before retirement and assess your comfort level with market fluctuations — two key factors in building the right asset mix for your portfolio.
Through Advisor.com, you can schedule a free, no-obligation consultation to discuss your retirement goals and long-term financial plan.
Ultimately, Vanguard’s BETR model offers a targeted way to evaluate Roth conversions.
Instead of relying on simple bracket comparisons or back-of-the-napkin math, this approach factors in opportunity cost, portfolio growth and how taxes are paid to show whether a conversion is likely to help or hurt over the long term.
It’s also wise to work with a tax or financial professional before making any moves. That’s because Roth conversions are often — but not always — a good idea.
The key is digging deeper before committing to what can be an expensive decision.
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Vanguard (1), (2)
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
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