Roth IRA Conversions – Part III
Posted @ 9:01 am - Filed under 401(k)'s & IRA's, IRS, Roth
Written By — Tom Anderson
This week, to wrap up this three-part blog on Roth IRA conversions, I am going to discuss the primary planning issues that need to be considered when evaluating the effectiveness of making a conversion to a Roth IRA. I am also going to lead you to a tool that can assist you in making a decision to convert or NOT to convert.
But first, let’s discuss how you can go about deciding. The basic idea is determining whether the cost of paying tax now on the amount converted is going to be exceeded by the time you tap your subsequent Roth IRA, when it will be exceeded, and what the resulting yield is on your money after the tax on the conversion. This then needs to be contrasted with the effective after-tax yield on your money if you did not convert.
Remember if you don’t convert from a traditional IRA or pension plan to a Roth IRA you will be required to begin taking minimum distributions from them commencing no later than April 1 of the year following the year you turn 70.5. Note: When you take the distribution in that following year it is for the prior year, so that you also have to take a current year minimum distribution as well.
Let’s say you convert in 2010, and you opt to pay the tax in 2010 (although, as previously discussed, you could choose to defer the tax liability to 2011 and 2012 — split equally), and that you convert a $100,000 IRA, and that your effective Federal and State tax liability rate combined is 43%. That means that your total tax liability won’t exceed $43,000. Let’s also assume that you do not pay that tax with the money in your IRA, allowing the full $100,000 to flow into your Roth. Let’s also assume that whatever you invest your Roth into and what you would have invested your traditional IRA in, had you not converted, was the same; resulting in the same yield (e.g., 10% annually). Now let’s assume that you get this yield (10% per annum) for five years and that you turn 59.5 in that fifth year, when you are eligible to take the money out of the Roth tax-free. That means that you’d have $161,051 tax-free from your Roth IRA.
On the other hand, if you do not convert, and assuming that your tax rate remains at 43% over five years and your reach 59.5, and then take a distribution from your traditional IRA, you would withdraw the same $161,051, and pay $69,251.93 in taxes, leaving you with $91,799.07. With the Roth example, assuming you converted having paid $43,000 on the $100,000 IRA at the time of conversion, later removing $161,051 tax-free, you would net ($161,051-$43,000) or $118,051 after-tax or $26,251.93 ($118,051-$91,799.07) more than had you not converted. Sounds pretty good. But remember that had you not converted you would have had an extra $43,00 to invest for five years (the amount of tax you would have paid to convert). If you invested that for five years at 10% (interest or dividends), that would have resulted in $69,251.93 gross based on earnings of $26,251.93, taxed at $43% each year, yielding $14,963.60 after tax. If you subtract that from the after-tax difference between investing the Roth IRA and the traditional IRA over the same five years, the benefit of converting over not converting is $11,288.33 ($26,251.63-$14,963.60). This amount is basically the advantage of growing and compounding the after-tax converted amount tax-free over the five-year period.
Of course, the example above is relatively simplistic, however, the variables affecting your decision-making are essentially the same, regardless of what set of assumptions you make for each variable:
1) What is your current tax rate (that will apply to a current conversion);
2) What will you tax rate be each year, post conversion;
3) What will your tax-rate be when you withdraw from your retirement account;
4) How much will you earn with your retirement account or your otherwise taxable investments.
5) How long will it be before you withdrawal funds from either your Roth IRA (if you convert) or your IRA (if you don’t)?
By the way, the above example, assumes that you do not use money from your retirement account to pay the tax due from conversion. If you did use retirement funds to pay the tax, conversion is not to your advantage in this example.
So that pretty much sums up the major factors to consider when deciding to convert or not to convert. There are, of course other advantages to a Roth post-conversion, as you are not required to withdraw from a Roth while you’re alive, as you are at 70.5 with a traditional IRA, furthering the benefits of tax-free compounding. In addition, your heirs can take tax-free minimum distributions over their expected lifetimes, unlike similar distributions from a traditional IRA, which would be taxable. Finally, there will less estate tax associated with Roth IRAs in years where the tax applies.
One final item to mention is that there is a software program (and maybe there are others), that I came across that automates the calculations and reporting for the process to evaluate the merits of converting to a Roth IRA. They have both a personal and professional version (for advisers). The cost is $175. You can find it here. There is also a free calculator I found here that you might try. Good luck and safe investing!
This entry was posted on Wednesday, March 24th, 2010 at 9:01 am and is filed under 401(k)'s & IRA's, IRS, Roth. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
