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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contributions and earnings may be withdrawn free of taxes provided we meet a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.
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
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
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.
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.
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