Roth IRA Conversions – The Basic Example
Friday, February 5th, 2010 by Cass Chappell, CFP®
The decision to convert Traditional IRA funds (or a 401k) to a Roth IRA can be a difficult decision. In many cases it involves the use of several assumptions. Changing those assumptions can change the decision an investor may make. Rather than attempt to develop a calculator that will “give us the answer”, let’s explore the relevant issues involved with making such a decision.
Once you understand the most important variables (and their impact to the analysis), this decision should be less intimidating.
Generally speaking, conversion to a Roth IRA involves paying taxes sooner than ordinarily would have been the case. A rational investor would rarely make this decision unless there was going to be some sort of payoff in the end.
The following is an example of parity between paying taxes now or later:
- An investor, age 60 has $10,000 in a Traditional IRA
- Assumed growth on the IRA is 10% per year
- Assumed tax rate is 35% for all years
- Investor pays taxes due on Roth conversion from funds within the Traditional IRA
- The Roth begins with $6500 ($3500 was sent to IRS to pay taxes on conversion)
- The investor has the same amount of money in either case if the tax rate is the same in all years and the taxes are paid from funds inside the Traditional IRA
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“CONVERT AND PAY FROM WITHIN” |
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IRA |
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Roth |
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Year 1 |
10000 |
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After Taxes > |
6500 |
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Year 2 |
11000 |
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7150 |
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Year 3 |
12100 |
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7865 |
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Year 4 |
13310 |
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8652 |
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Year 5 |
14641 |
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9517 |
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Year 6 |
16105 |
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10468 |
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Year 7 |
17716 |
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11515 |
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Year 8 |
19487 |
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12667 |
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Year 9 |
21436 |
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$13,933 |
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Taxes > |
7503 |
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Value |
$13,933 |
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“Convert and pay from within” assumes |
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The Roth is created after the payment |
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of taxes from the IRA |
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No 10% penalty on the withdrawal to pay |
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taxes |
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Withdrawal made as a lump sum from the |
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IRA at the end of the last year |
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Client is over 59.5 at beginning AND end of last year |
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Conclusion: If an investor can’t pay the taxes due on conversion from a source other than the Traditional IRA, it may not be a benefit to convert……unless the investor expects to be in a higher tax bracket when the withdrawal is made.
Same example as above, except:
- Assumed tax rate this year is 35%
- Assumed tax rate at withdrawal is 41%
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“CONVERT AND PAY FROM WITHIN” |
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IRA |
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Roth |
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Year 1 |
10000 |
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After 35% Taxes > |
6500 |
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Year 2 |
11000 |
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7150 |
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Year 3 |
12100 |
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7865 |
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Year 4 |
13310 |
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8652 |
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Year 5 |
14641 |
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9517 |
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Year 6 |
16105 |
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10468 |
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Year 7 |
17716 |
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11515 |
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Year 8 |
19487 |
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12667 |
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Year 9 |
21436 |
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$13,933 |
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Taxes > |
8789 |
41% |
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Value |
$12,647 |
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“Convert and pay from within” assumes |
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The Roth is created after the payment |
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of taxes from the IRA |
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No 10% penalty on the withdrawal to pay |
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taxes |
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Withdrawal made as a lump sum from the |
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IRA at the end of the last year |
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Client is over 59.5 at beginning AND end of last year |
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This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
