Retiree Portfolio The Question of Conversion

By David Braze (TMF Pixy)
December 20, 1999

Unless you have been stranded for the last two years on a desert isle bereft of all communications devices, then you couldn't possibly have missed all the hoopla surrounding the Roth IRA, which burst into the financial world on January 1, 1998. (Its rules are explained fully in our IRA area.)

The Roth provides a new, powerful means to save for retirement and accumulate wealth. It's unlike any savings tool. We can't get a tax deduction for making a contribution to it, but after the Roth IRA is established, all contributions and earnings may be withdrawn free of taxes provided we meet a few simple conditions. Unlike traditional IRAs, no withdrawals are mandatory, and should we die our heirs will receive the entire balance tax-free. Additionally, provided our AGI is no more than $100,000 and we pay all taxes previously deferred, we may convert existing traditional IRAs to a Roth IRA. On conversion, these IRAs will also enjoy the tax-free benefits provided by the Roth.

On the surface, retirees may think converting traditional IRAs to a Roth IRA may be attractive. But is it? Like all things, it just isn't that simple. The conversion question is so personal that each and every individual must really look at the issues, understand the tax pros and cons, and realize that there are other "non-tax" and even "non-financial" reasons to convert or not to convert. In addition, the conversion decision rests on a number of factors such as tax rates today versus those of tomorrow, how you would pay taxes due on the conversion, how long the money can stay in the converted account, and the size of your estate. To see what I mean, let's look at two examples.

Jane, age 60, is retired. She has $50,000 in a previously untaxed traditional IRA that she knows she won't touch for at least five years, and perhaps longer. She wants to convert that IRA to a Roth IRA. She expects the return in either the Roth IRA or the traditional IRA to be 10% per year. Jane cannot afford to pay the income taxes due on the conversion, so she will keep enough money from the transfer to pay all taxes due in 1999. She wants to know if the conversion will result in more after-tax funds to support her retirement needs if her marginal income tax bracket drops, increases, or stays the same when she starts withdrawing money from the converted IRA.

Jane's first problem is to determine how much she must withdraw from the traditional IRA to pay her taxes. In this case, we'll assume that the entire conversion will be taxed at her marginal income tax rate of 28%. Thus, she would owe Uncle Sammy $14,000 on the conversion. The remaining $36,000 will then go to the Roth IRA where it will earn 10% annually until the proceeds need to be taken. The table below shows the after-tax results of using the Roth or leaving the money in a traditional IRA after a number of years have passed. It assumes the traditional IRA is taxed at the marginal tax rates shown. Nothing in the Roth IRA is taxed after the initial conversion.

                  Roth IRA Conversions
        Income Taxes Due Paid from Converted IRA

                        Trad IRA After Taxes   
                        at Marginal Bracket
                    =============================
    Year |  Roth   |   15%   |   28%   |   31% 
    =============================================
     5   |  57,978 |  68,447 |  57,978 |  55,563  
    10   |  93,375 | 110,234 |  93,375 |  89,484 
    15   | 150,381 | 177,533 | 150,381 | 144,115 
    20   | 242,190 | 285,919 | 242,190 | 232,099 
In this simplistic example, using part of the traditional IRA money to pay the income taxes due on conversion results in less after-tax money in the Roth should Jane's marginal income tax bracket fall after the conversion. If her marginal bracket remains the same, neither IRA has an advantage. If her tax rate increases, then the Roth will provide her with a greater after-tax stash from which she may meet income needs.

For our second example, Jane is still in the 28% tax bracket and still has a $50,000 traditional IRA she wants to convert to a Roth IRA. This time, though, she will pay all taxes due on the conversion from other assets. To do so, she will withdraw the taxes due on the conversion from a regular investment account. That taxable account has an after-tax return of 9.16% per year. (Note: The total return on this account is 10%, of which 3% comes from taxable dividends and 7% comes from long-term capital appreciation.) For fairness, the lost principal and growth on the money taken from her taxable account must be added to the traditional IRA proceeds. I assume that if not used for taxes during the conversion, then the money could have grown through the years and been available for withdrawal in the future. Assume the growth in this taxable investment would be taxed at a long-term capital gain rate of 20% for a taxpayer in the 28% marginal bracket and at 10% for one in the 15% bracket. The table below shows the after-tax results of this approach

                     Trad IRA and Taxable Account
                       After Tax Impacts at the   
                        Marginal Bracket Shown
                    =============================
    Year |  Roth   |   15%   |   28%   |   31% 
    =============================================
     5   |  80,526 |  87,976 |  75,337 |  72,922  
    10   | 129,687 | 140,504 | 120,281 | 116,390 
    15   | 208,862 | 224,449 | 192,084 | 185,818 
    20   | 336,375 | 358,637 | 306,828 | 296,737 
The above table shows that if Jane remains in the 28% tax bracket, the use of other assets to pay the taxes due on the conversion makes the Roth IRA a clear winner because the total of her traditional IRA and her investment account after taxes is less than the total for the Roth IRA. If her marginal tax rate drops to 15% when she begins withdrawals, the traditional IRA is best. If her tax bracket increases, then again the Roth wins. In this instance, then, when taxes due on the conversion are taken from other taxable assets, the Roth IRA is a more attractive option for those who remain in the same tax bracket or go to a higher marginal tax rate at the time of withdrawal. For those who drop to a lower tax bracket, the Roth IRA again loses.

I provide these overly simplified examples to highlight that converting a traditional IRA to a Roth IRA may or may not make sense. Each of us must make our own analysis of this issue. What is our tax rate today versus that of tomorrow? How do we intend to pay the taxes due on the conversion? Are there estate issues involved? In short, we need to think the whole thing through before we act. Otherwise, we may make a mistake that is totally avoidable with a little prior investigation.

That's it for this week. In our next thrilling chapter we'll look at what to withdraw first -- money in taxable accounts or funds in tax-deferred accounts? The answer may prove surprising.

Have a happy holiday!

Best to all... Pixy