To Roth, or Not to Roth
Tuesday, April 6th, 2010 by Cass Chappell, CFP®
My official “stance” on the Roth Conversion opportunity
Executive Summary:
It’s at the bottom of this post. But, read the whole article…it’ll be more fun.
In a prior post, I showed how using funds WITHIN the IRA to pay taxes on the conversion does not provide a substantial advantage, even when the assumptions used are favorable to the decision (lower tax now, higher tax later). It is important to note that this strategy works in even fewer situations if the investor is under 59 ½ (because there is also a 10% penalty on the funds taken out to pay the taxes).
So clearly, we have established one of the main conditions that needs to be satisfied before going any further with the analysis:
“Can you pay the taxes that are due on the conversion with funds from OUTSIDE the IRA?”
If the answer is “No”, then the best play may be to do nothing.
Keep in mind, this decision (whether or not to convert traditional IRA funds into a Roth) is not an “all or nothing” proposition. As long as you can afford to pay the taxes on at least a partial conversion, then you will want to keep reading.
Before we get to the charts…
$100,000 in a traditional IRA (or rollover IRA, or anything like it) isn’t really worth $100,000. Taxes need to be paid. The amount of the IRA that will go to taxes will vary based on your income at the time you take the money out of the IRA.
The maximum tax rate in 2010 is 35% for federal and 6% for Georgia (41% total).
SO…A Traditional IRA that has a balance of $100,000 is really only worth something more than $59,000 (if you accessed it in 2010 – and you are over 59 ½). How much more depends on what your tax bracket is.
$100,000 in a Roth IRA, on the other hand, really IS worth $100,000. As long as you are over 59 ½ (with a few exceptions) the account can be accessed tax-free.
Sounds easy, right? Pay the taxes now (in this case $41,000) and that $100,000 Traditional IRA that wasn’t really worth $100,000 anyway is now a Roth IRA that is worth the full $100,000. In other words, by sending $41,000 to the government to pay taxes, you have increased the REAL value of your retirement account by that same dollar amount.
That statement is true ONLY if your tax rate in the future is the same as it is today.
While that could be the case, it isn’t likely to be. Tax laws change frequently. Who knows what the future of taxes will be? (if you know, please call me)
Another issue that hasn’t been considered is the loss of the $41,000 that was just sent in for taxes. Had you not made the conversion, you still would have had the 41 grand.
There is an opportunity cost on the money used to pay taxes.
Our analysis must compare:
An investor who has a $100,000 Traditional IRA AND the money in a taxable account that would be used to pay taxes
With an investor who converted a $100,000 Traditional IRA into a Roth IRA (and thus no longer has those taxable account funds – because they were used to pay taxes)
Important points:
Under current tax law, money outside of an IRA is taxed differently than money inside an IRA. Interest, dividends, and capital gains realized on these funds in the taxable outside account are all taxed a little bit differently.
In this analysis, I am using 15% as the combined tax rate, each year, for growth on the taxable account. This is meant to be a conservative tax rate. There are many situations where the tax burden would be much higher (under current tax law).
Assumptions:
- 8% growth, each and every year, on all investment accounts
- 25% combined tax rate on Traditional IRA distributions now
- 15% tax rate on the taxable account in all years – taxes due paid from taxable account balance
- 25% combined tax rate on Traditional IRA distributions in future years
This is a hypothetical example and not representative of a specific situation. Your results will vary.
Observations:
- With identical tax rates for Traditional IRA distributions now and in the future, the investor who converted fared better
- The difference is caused by the fact that the taxable account is taxable
- By paying $25,000 in taxes, the investor has virtually exchanged $25,000 in taxable funds for $25,000 of increased value in the Roth IRA that will grow tax free (with a few exceptions)
- A higher tax rate in future years would give an even bigger advantage to the Roth conversion
Let’s see what happens when the tax rate on Traditional IRA distributions is LOWER in the future
Assumptions:
- 8% growth, each and every year, on all investment accounts
- 25% combined tax rate on Traditional IRA distributions now
- 15% tax rate on the taxable account in all years – taxes due paid from taxable account balance
- 20% combined tax rate on Traditional IRA distributions in future years
This is a hypothetical example and not representative of a specific situation. Your results will vary.
Observation:
- The investor who converted is at a disadvantage
Conclusions and Comments:
- Converting a Traditional IRA to a Roth IRA and paying the taxes with funds from OUTSIDE the IRA may benefit an investor who is in the same, or higher, tax bracket in the future
- If the investor will be in a lower tax bracket in the future a Roth conversion seems to give a much smaller advantage (and it could actually be a disadvantage)
- It is very difficult to predict what tax bracket you will be in next year, let alone 10 years from now
- Tax brackets are always changing
- Historically speaking, taxes are currently as low as they have EVER been
- While it is possible (and some say probable) that taxes will be higher in the future, no one knows
“So Cass. What are you telling your clients?”
Drum roll please……………………
- If you can easily afford to pay the taxes due on a conversion from funds outside the IRA, AND
- If it is at least somewhat likely that you may be in the same, or higher tax bracket in the future, THEN
- Roth Conversion may be for you
- But, talk to a knowledgeable advisor first
Please talk to your tax advisor about your situation prior to executing any strategy.
