Roth Conversions - Deductible vs. Nondeductible; Traditional vs. Nontraditional - IRAs

Several articles have been written on how to convert a Traditional IRA to a Roth IRA, but I have not seen a good article that analyzes who should do it and who should not. Please let me memorialize the factors I look at when I am asked that question.

First let me tell you about a woman who came to me to have her tax return done. This happened over 20 years ago but things like thing are happening all the time. She was a 50 year old nurse's aide with a small IRA. Her son just got a job with a large insurance company and he told her that she should roll her entire Traditional IRA into a Roth. Of course she listened to her son, and paid the taxes. The tragedy of this is that she is now retired and living on Social Security plus a few dollars from the Roth. She pays no tax; if she was withdrawing the money for a Traditional IRA she still would not pay any tax. All the taxes she paid to convert the IRA was a waste of money.

Factor 1- Tax Rates Now vs Tax Rates at Retirement

In order to make a decision on Roth conversations it is necessary to compare the rate you would pay on the conversion with the rate you most likely will be taxed at during retirement. If you are at the 33% rate now and you will be at the 20% rate at retirement, a conversion may not make sense.

Also, large conversions can be problematic because they may be taxes at a higher rate than the rate you are normally taxed at. This only increases the possibility that the rate at retirement will be less.

Factor 2- How Much Time Will The Money Be In the IRA

The advantage of the Roth is that it grows tax free. The longer the funds are in the IRA the more growth there is and the better chance the Roth is the way to go.

Factor 3- Can You Pay the Tax on Conversion and Still Make Your Maximum Contributions Without Using the IRA Funds

It doesn't do any good to roll money from a Traditional IRA to a Roth if you have to keep part of the proceeds to pay the tax. For example:

Assume you have $60,000 in a Traditional IRA and you will have to pay $20,000 in tax (33.3% rate) if you roll it into a Roth. If you do a rollover and use $20,000 of the proceeds to pay the taxes, you will have $40,000 in a Roth vs $60,000 in a Traditional. If your money tripled by the time you withdraw it, you will have $120,000 in the Roth or $180,000 in the Traditional. If the withdrawals from the Traditional are taxed at 33.3% you would have $120,000 after tax. The conversion did not save you anything, but most people are in lower tax brackets after retirement. If you were paying 20% on the withdrawals from the Traditional, your tax on the $180,000 would be $36,000 leaving you with $144,000, which is $24,000 more that the Roth.

It takes a very unusual set of circumstances for a Roth conversion to be profitable when you need part of the proceeds to pay the tax. Also, don't pay the tax with funds that you could contribute to an IRA.

Now to demonstrate the impact time and tax rates:

Assume that you have $30,000 in a Traditional IRA and an extra $20,000 in savings that you can invest. Also you and your spouse are eligible to make $10,000 in Roth contributions. Let's analyze the following options:

• Do nothing; keep the traditional and keep the savings.
• Roll the Traditional IRA to a Roth and use $10,000 of the savings for taxes and keep the rest in savings.
• Roll the Traditional IRA to a Roth and use $10,000 of the savings for taxes and make an additional contribution to the Roth for $10,000

The table below, which assumes a 4% return on investment, shows how much you would have after tax in 10, 20, 30, 40, and 50 years, assuming tax rates upon withdrawal of 10%, 20% and 33%:

What do we learn from the above table:

• The difference between the rates paid at the time of conversion and upon retirement is a key factor. If your tax rate difference is very significant ( 33% now and 10% at retirement), Roth conversions seem to be out of the question. Note not converting always won when there was a difference of 23%.
• Time can make up for a small difference in tax rates. After 30 years, when the rate declined 13% (from 33% to 20%) the balance was almost equal ($130,250 vs. $129,736). A 40 or 50 year investment can more than make up for the 13% reduction is tax rates availiable at retirement. Please note that after 50 years, the balance was $284,267 by converting when the rate at retirement was 20%, while the balance not converting was $273,307. The long period of time made up for the loss due to lower tax rates; the younger the taxpayer the more profitable a conversion can be.

Generally, retirees are in lower tax brackets after retirement. Their incomes decline. Some or all of their Social Security is not taxable. Many states do not tax some of or all of their pension income. Retirees are free to move to low tax states, like Florida, which does not have an income tax.

Unless a retiree has substantial income, they will want some income from taxable IRAs. They want to take advantage of the low tax brackets. It would be big a mistake not to have taken deductions at 28% or more and then find that you are in a zero or 10% bracket at retirement.

Most retirees want some money in Roths even if they are going to be in the 10% bracket at retirement. Roths are used to avoid a spike in income. If you need a new car the funds should come from a Roth.

Impact of Rates of Return

The above table used a 4% rate of return. What if the rate of return was more? An analysis at 8% revealed that compounding tax free can make up for a 13% unfavorable variance in tax rates in just 20 years which is 10 years less than it is at a 4% rate. At a little over 50 years a 23% unfavorable tax rate variance can be overcome.

Conclusion by Age

20 to 40:

The Conversion is the answer; there could be 50 or more years of compounding? If the Traditional Roth is large, do the conversion over a number of years.

40's:

If you are going to need your retirement funds, small conversions may be advantageous if you don't have any money in Roths. Don't do large conversions because they could be taxes at rates that are substantially above what you will be paying at retirement.

If you do not need these funds for retirement and you will be in a high tax bracket after retirement, a conversion is a good strategy. These funds could compound until you die.

50 and up:

Caution should me taken. You do not want to pay more taxes now than you would at retirement. It makes sense in a year that your income is down below what you expect it to be in the future, but, the conversion should not put you in a higher tax bracket than you expect to be in the future.

The irony is that over 95% of my clients who are considering conversions are over 60. The benefits in conversions are at younger ages.

The concepts discussed above were applied to the question of whether it is better to make a Traditional or a Roth Contribution at the blog linked below.