In his thoughtful response yesterday to a reader’s question about retirement readiness, fellow Seeking Alpha contributor Maksim Netrebov briefly addressed that reader’s inquiry regarding the wisdom of a Roth conversion (from her 403-b plan) upon her impending retirement.

Noting that the reader was likely to run out of money at a fairly early age (by age 80 at the latest) without curtailing her spending, he subsequently wrote:

If we are assuming that you will live on less money in the future, why do a conversion now and pay 25% or more in taxes when you can expect to draw less money in the future and thus pay less taxes at that time?

That basic analysis is essentially correct, but I think the question warrants a deeper dive into the mechanics of a Roth conversion, and how a retiring individual should think about when (or if) to convert some or all of their retirement assets into a Roth account.

How does a Roth IRA differ from a traditional IRA?

First, let’s get the basics out of the way, for those who might not fully understand them (if you’re already well-versed, you can probably skip ahead to the next section now). In a traditional IRA, income is stashed away tax-free in the year of initial earnings, and that pre-tax money is left to grow tax-deferred until retirement. No taxes are paid on the contributed funds in the year of contribution, nor are they paid on investment earnings as they come in—taxes are only paid when the funds are withdrawn in retirement, at which point all withdrawals (both contributions and earnings) are taxable at ordinary income rates. The IRS doesn’t give an eternal free lunch, of course, so they do require that retirees begin making withdrawals (called Required Minimum Distributions, or “RMDs”) at age 70-1/2.

In a Roth IRA, though, the math is flipped. For a Roth, contributions are made on an after-tax basis (taxes are paid in the year of contribution), and all future investment earnings and withdrawals are completely tax-free. Because taxes are paid upfront and not deferred, the IRS has no RMD requirements on Roth accounts; the cash can stay in a Roth indefinitely, as long as the retiree lives (after death, there can be some different withdrawal requirements for heirs, but we’ll revisit that point later).

The decision on whether to contribute to a Roth or a traditional IRA depends entirely on what your relative tax rates will be, now and in the future. If your tax rate is higher now than it will be in your retirement years, then you should choose the traditional IRA route (defer taxes until the later, lower-tax-rate years). But if you expect your tax rate to be higher in retirement than in the current year, then the Roth is the better option. Here’s a quick graphic that summarizes the decision:

(click to enlarge)

Of course, there are also income limits that determine your eligibility for contributing to a Roth in a given year, so in many cases, the decision makes itself. As a general rule, if you think you’ll be close to the Roth IRA income threshold in a given year, then your tax rate is probably high enough for you to be leaning toward a traditional IRA, anyway.

For a Roth conversion, though (as opposed to a single-year contribution), the income limits are irrelevant, and the analysis needs to be amended somewhat.

What is a Roth IRA Conversion?

In the case of a Roth conversion, a worker can take an accumulated balance in an IRA account (or a 401-k account, assuming that the worker has separated from service) and convert the entire balance to a Roth account by paying taxes on the converted amount in the current year. Conversions used to be subject to an income limit (similar to Roth contributions), but that limit was permanently repealed in 2010, meaning that anyone is now eligible to make a Roth conversion, regardless of their current income level or the size of the account being converted.

The question, then, is when does a conversion make sense? For younger workers, the decision is a fairly complicated one. It’s easy to know what the current year’s tax rate will be, but predicting tax rates in retirement is often a difficult task.

Two primary considerations impact a worker’s retirement-year tax rate: first, what will overall tax policy look like in the future? Most Americans seem to expect that tax rates have nowhere to go but up: rates are currently at historically low levels, and with the national debt continuing to grow, it’s a fair bet that they at the very least won’t be declining any time soon.

The second issue is what I’ll call the “individual life-cycle” of tax rates. For most workers, tax rates are low when they’re young, begin to climb as their incomes rise in their prime working years, and then decline swiftly as they retire and their income slows or halts entirely (for many retirees, RMDs from their retirement accounts are their only income, aside from any incoming Social Security benefits).

All else equal, then, the only two groups of people who should realistically be considering Roth conversions are younger workers and recent retirees. Younger workers face much more uncertainty in the decision than their older counterparts, but that hasn’t stopped them from embracing the Roth in staggering numbers: by one measure, workers under the age of 35 had eight times as many assets saved in Roth IRAs than in traditional IRAs.

So, what should a recent retiree do?

For recent retirees, the decision of whether or not to convert is actually a fairly simple one, since the relevant variables are so much easier to project. Yes, tax policy—like any government policy—is always hard to predict with 100% confidence, but it’s much easier when we’re planning for only 15 or 20 years, as opposed to 50 or 60. In most cases, it’s fair for retirees to assume that the tax rate schedule will be essentially unchanged during their retirement years.

But more importantly, a recent retiree has almost perfect information about his or her own future income path, and so the second consideration has essentially zero uncertainty. Yes, investment returns over time will impact the amount of any RMDs from a traditional IRA, and some years will see larger withdrawals than others due to unforeseeable variations in expenses (like medical costs or home repairs), but for the most part, income variation in retirement is something that is entirely within the control of the retiree, and hence very easy to predict and plan for.

As a case study, then, let’s consider the case of the reader from yesterday’s article. Borrowing from Maksim’s analysis, we start with the following information:

$700,000 of 403(b) assets at retirement age 60

Annual Social Security income of $31,668

Required annual income of $80,000

Annual investment return of 6.5%

Let’s first look at the scenario in which our reader converts the entire 403(b) balance in Year 1 of retirement, thus generating $700,000 of taxable income. If we assume that the $700,000 represents the reader’s only income in the year of conversion, and that the reader is filing an individual return and taking the standard deduction, then we can calculate the estimated tax bill for the Roth conversion at $230,875, leaving a starting Roth IRA balance of $469,125 (note that there is a lingering question as to how that hefty tax bill will be paid, but we’ll address that in a later section).

Since the reader’s entire balance is now held in a Roth account, the only income we expect the reader to report in future years is from Social Security earnings, since Roth withdrawals will be tax-free. That means that the Social Security earnings will likely also be tax-free (because there are no other sources of income), so the $230,875 represents the last income tax bill the reader will ever pay. Yes, that’s an obvious oversimplification of a complex issue, but we’ll let it stand for the purposes of illustration.

In a second scenario, the reader does not convert anything at all, and simply draws roughly $48,000 from her 403(b)/traditional IRA each year as it is needed, paying taxes bit by bit over time. Again, estimating a tax bill requires making some assumptions, but areasonable assumption of annual taxes (on the combined amount of Social Security and any IRA withdrawals) is about $12,000.

Given that Maksim correctly projected that the reader would run out of money within about 20 years of retirement, this means that by converting to a Roth, our reader will have paid $230,875 of taxes upfront in order to avoid $240,000 of lifetime taxes. Again, that comparison is a bit of an oversimplification, but it does confirm Maksim’s initial reaction that the decision whether or not to convert is a fairly minor one, and not one that will make a huge difference one way or the other.

However, there is a third option that should also be considered. What if, instead of converting 100% of retirement assets in Year 1 of retirement, the reader converted 20% of assets per year, over a 5-year period? Turning again to our tax estimator, and assuming a conversion of $140,000 of assets per year over 5 years, that gives us an estimated annual tax bill of $29,339, for a 5-year total of $146,695. That does represent a significant potential tax savings, and should certainly be considered.

The tax savings mostly stems from avoiding the huge tax payments that come from pushing one’s income into the highest tax brackets—when we convert everything in Year 1, the vast majority of the converted amount is taxed at rates of 33% or above, with nearly $300,000 of it falling subject to the top tax rate of 39.6%. The tax bill of $230,875 represents about 33% of the amount converted, which is an obviously high tax rate.

In the case of the 5-year graduated conversion strategy, though, not a dime is ever taxed at a rate above 28%. The annual tax bill of $29,339 on income of $140,000 represents a rate of just 21%, a steep drop from the previous 33%.

By being thoughtful and considering how best to spread income across several years (rather than just cramming it into one year), a certain type of tax arbitrage can be achieved.

But, we do need to think about Social Security

However, if we claim Social Security early, as our reader had intended, that decision can impact our flexibility with respect to partial conversions, by increasing our income (and tax rates) in the years in which we’re attempting to convert. My calculations above assumed that there was zero Social Security income in any of the 5 partial-conversion years. Adding back in Social Security benefits can change that math significantly, adding as much as $10,000 per year to the total tax bill.

It’s always best to delay Social Security benefits as long as possible, so as to take advantage of the delayed credits. At the very least, retirees should wait until age 66, if not age 70. For an individual like our reader, there’s no financial reason why she needs to take benefits early, since she has ample retirement assets to cover her expenses. And since the presence of those benefits can have some unwanted tax consequences that might impact the reader’s flexibility with respect to Roth conversions and tax optimization, it’s best to leave them out of the equation entirely until the “big stuff” has been sorted out.

Decisions about Roth conversions and decisions about Social Security claiming strategies are rarely independent; on the contrary, any retiree should think about all sources of income in a comprehensive manner, recognizing that decisions in one arena can affect decisions in another.

What about paying the tax bill?

In the case of our reader, this won’t be much of an issue, but for younger retirees, it’s also relevant to consider how the tax bill will be paid on any Roth conversion. If an individual doesn’t have enough cash on hand to pay the bill, then paying it out of the converted retirement assets won’t always be an option. Early withdrawals from retirement accounts (those occurring before age 59-1/2) are subject to a 10% penalty on top of any taxes owed, so if you’re relying on your retirement assets to cover your tax bill, you could quickly evaporate any benefit of a Roth conversion.

Again, for the reader in question, this shouldn’t be a major problem, since she won’t be making any conversions until she’s already reached age 59-1/2, but making the withdrawals from the accounts can still be a bit of a headache, and it’s best to have enough cash on hand to pay the necessary taxes before any conversions are made.

Estate planning considerations also matter

Our reader also said that estate planning considerations are not a major factor (and since Maksim projected that she’d run out of money, they likely won’t be), but it does bear mentioning that sometimes a Roth IRA can be a terrible asset for an heir to inherit. If your heirs are in low tax brackets, but you’ve paid taxes at a high rate in order to convert to a Roth, then your heirs would have been better off if you hadn’t converted, and had instead let them pay taxes at their own tax rates after your death. In the case of an inherited IRA, it’s also relevant to understand the rules regarding withdrawal requirements, which can vary depending on how the IRAs are set up (and the relationship of the named beneficiary to the decesased).

Finally, in a quick but nuanced point for those who may owe estate tax (an admittedly small minority, since less than 1% of Americans will owe estate tax when they die): a Roth conversion could also help avoid estate tax by minimizing the total size of the estate at death. Remember, when calculating estate tax, the IRS doesn’t particularly care whether or not your estate assets have embedded tax liabilities. The only thing that matters for the purposes of an estate tax calculation is the total numbers on the account statements, irrespective of asset type. So, even though a Roth can sometimes be a bad asset to inherit, it could also theoretically be a great one to inherit, since it could avoid estate taxes. A comprehensive consideration of the relative tax impacts of different strategies may be necessary, and should be thoroughly considered before any Roth conversion strategy is implemented.