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Retiree Portfolio Convert to a Roth IRA?

The ability to ultimately take tax-free withdrawals from a Roth IRA makes the conversion of a traditional IRA to a Roth seem attractive. However, that's a decision that has no "one size fits all" answer. Each of us must analyze this option based on our individual circumstances. The conversion decision depends on a number of factors, including your tax rates today versus those of tomorrow, how the taxes due on the conversion will be paid, the size of your estate, and your plans for the estate.

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By David Braze (TMF Pixy)
January 8, 2001

Roth IRAs first became available in 1998. Because it ultimately allows tax-free withdrawals of all proceeds, the Roth IRA has become a popular savings vehicle. Under one feature of Roth law, single and joint taxpayers may convert traditional IRAs to Roth IRAs provided their AGI (adjusted gross income) is less than $100,000 in the year of conversion. On conversion, ordinary income taxes must be paid on previously untaxed traditional IRA proceeds. Those taxes are due in the year of the rollover to the Roth. If money is taken from the traditional IRA to pay those taxes, those who are younger than age 59 1/2 must also pay a 10% early withdrawal penalty on that distribution.

The decision to convert a traditional IRA to a Roth IRA is not cut and dried. The question is so personal that we must really look at the issues, understand the tax pros and cons, and realize that there may be other nontax and even non-financial reasons to convert or not to convert. In addition, the conversion decision rests on a number of factors, such as your tax rates today versus those of tomorrow, how the taxes due on the conversion would be paid, the size of your estate, and your plans for the estate. Let's look at two examples that will highlight just the income tax issues involved.

Jane, who is younger than age 59 1/2, has $50,000 in a previously untaxed traditional IRA. She wants to transfer that IRA to a Roth IRA. Her return in either type of IRA will be 9% per year. Jane cannot afford to pay the income taxes due on the conversion, so she will keep enough money from the rollover to pay all taxes due. She wants to know if the conversion will result in more income for her in retirement. She assumes her marginal income tax bracket will remain unchanged.

In this situation, first we must determine how much Jane must withdraw from the traditional IRA to pay her taxes and the 10% penalty that will be due on that withdrawal because she is younger than age 59 1/2. This can be done by using the formula W = T + 0.1W in which W is the total withdrawal and T is the total amount of taxes due on the value of the converted IRA. The formula can be reduced to 0.9W = T.

If Jane is in the 15% marginal bracket and if her IRA is worth $50,000, then on conversion she will owe $7,500 in ordinary income taxes ($50,000 times 0.15). That means:

0.9W = T
0.9W = $7,500
W = $7,500 / 0.9 = $8,333

Jane can then withdraw $8,333 from her traditional IRA, convert the remainder ($41,677) to the Roth IRA, and have enough to pay her income taxes of $7,500 plus her $833 early withdrawal penalty. The $833 is 10% of the total amount withdrawn from the converted IRA.

After-tax comparisons of the Roth IRA to the traditional IRA for each marginal tax rate are shown in the table below. In every case, the Roth IRA fails to match the after-tax results of the unconverted traditional IRA. This failure is due to the lost investment opportunity on the money she withdrew from the converted IRA to pay her taxes and penalty on the conversion.

                   Roth IRA Conversion
     Income Taxes and Penalty Paid from Converted IRA
 
       15% Bracket       28% Bracket       31% Bracket  
 
                Trad              Trad              Trad
                 IRA               IRA               IRA
               after             after             after
Year   Roth      Tax     Roth      Tax     Roth      Tax
5    64,110   65,392   52,996   55,390   50,433   53,083
10   98,641  100,613   81,541   85,225   77,597   81,674
15  151,771  154,806  125,462  131,129  119,393  125,666
20  233,519  238,187  193,038  201,759  183,701  193,352
25  359,298  366,481  297,013  310,431  282,647  297,496
30  552,824  563,876  456,992  477,636  434,888  457,735

Be aware that if Jane were over the age of 59 1/2 (and as long as she remains in the same marginal income tax bracket), then neither the Roth nor the traditional IRA, after taxes, would have an advantage over the other. The Roth balances would exactly equal the after-tax balances in the traditional IRA for all time periods. However, if her marginal income tax bracket dropped in retirement, then the unconverted traditional IRA would be her best option after taxes. If her marginal tax rate increased, then the conversion to a Roth IRA would be her better option.

For our second example, assume Jane is in the 28% tax bracket and has a $50,000 traditional IRA she wants to convert to a Roth IRA. She will pay all taxes due on the conversion from other assets. (Doing so avoids the early withdrawal penalty for being younger than age 59 1/2.) She will withdraw the taxes due from a regular investment account that has an after-tax return of 8.244% per year. (Note: The total return is 9%, of which 30% comes from taxable dividends and 70% comes from long-term capital appreciation.)

For fairness, the lost principal and growth on her withdrawal from that account must be added to the potential traditional IRA proceeds. If she does not use the money to pay taxes due on the conversion, then the taxable investment would grow through the years and be available for withdrawal in retirement. Growth in the taxable investment account will be taxed at a long-term capital gain rate of 20% on withdrawal for a taxpayer in the 28% marginal bracket, and at 10% for one in the 15% bracket. The following table shows the after-tax results of this approach when Jane remains in her present tax bracket of 28% or falls to a 15% marginal tax rate at the time of withdrawal.

                   Roth IRA Conversion
   Income Taxes and Penalty Paid from Other Assets

                       28% Bracket        15% Bracket
                    IRA & Inv Acct     IRA & Inv Acct
Year       Roth    After-Tax Total    After-Tax Total
5        76,931             74,834             85,515
10      118,368            112,757            129,836
15      182,124            170,681            197,551
20      280,221            259,172            301,027

The above table reveals that if Jane remains in the 28% tax bracket at withdrawal, the use of other assets to pay the taxes due on the conversion of her old IRA makes the Roth IRA a clear winner. However, if her marginal tax rate drops to 15% when she begins withdrawals, then the combination of her traditional IRA and taxable account, after taxes, would be best for her.

These examples indicate that a conversion to a Roth IRA is an inferior option to a traditional IRA for those under the age of 59 1/2 when funds are taken from the traditional IRA to pay the resulting income taxes and early withdrawal penalty. For those older than age 59 1/2 who remain in the same income tax bracket both before and after retirement, neither approach has an advantage over the other. For those who drop to a lower tax bracket at withdrawal, an unconverted traditional IRA is superior to a conversion to a Roth IRA.

When income taxes due on the conversion are taken from other taxable assets, the Roth IRA is a more attractive option. In that case, the Roth IRA is a clear winner for those who remain in the same marginal tax bracket at the time of withdrawal. It loses to the unconverted traditional IRA only when the marginal tax bracket drops in retirement.

That's it for this week. See you next Monday. As usual, post your comments on the Retirement Investing or the Retired Fools boards.

Best to all... Pixy


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