The Roth IRA is one of the most powerful tax and retirement planning tools available, yet it is misunderstood and often misused. Many financial advisors have labeled 2020 as the best time to convert all or part of an IRA. Income taxes, and the cost of converting an IRA, might never be lower in the future than in 2020 and 2021. The tax reductions of the Tax Cuts and Jobs Act are scheduled to revert to their old levels after 2025. They might increase sooner if Congress decides it needs more money to pay for its spending.
The investment income in a Roth IRA compounds tax free, and most Roth IRA distributions are tax-free. In addition, there are no required minimum distributions (RMDs) during the original owner’s life. Distributions also are tax free to beneficiaries who inherit a Roth IRA. But most beneficiaries must empty the Roth IRA within 10 years after inheriting it under the rules created in the SECURE Act. See this month’s Estate Watch article.
Unlike a traditional IRA, the benefits of a Roth IRA are backloaded. You receive no deduction for contributing to a Roth IRA but must make your contribution with money on which you’ve already paid income taxes.
Most Roth IRA contributions are made is by converting a traditional IRA to a Roth IRA.
But you have to include in gross income the amount you convert just as though it had been distributed to you. That means you pay income taxes on the amount that’s converted.
Many people hesitate to convert an IRA, because they aren’t sure it will pay off in the long term. They don’t like the idea of paying taxes now instead of in the future. Also, too many people try to make a conversion decision through intuition or by considering only a few factors.
A number of factors determine whether a conversion will increase after-tax wealth over time. That’s why I built my IRA Conversion Spreadsheet. It’s an Excel spreadsheet that allows you to change many different factors, comparing the results of a conversion to the status quo under different assumptions about tax rates, investment returns, holding periods, the amount converted, how long withdrawals are delayed, and more.
Let’s consider the hypothetical case of Max Profits. He has a large IRA and is considering converting $50,000 this year, when he’s 60.
Max first assumes he’ll earn an 8% pre-tax investment return in his pre-retirement years and 6% after retiring. His effective ordinary income tax rate now and during retirement will be 28.75%. Max estimates the effective tax rate both before and during retirement on his taxable investments will be 19.25%, after blending long-term capital gains, short-term capital gains, qualified dividend income, and interest income.
Max expects to begin distributions from the IRA at age 70. He’ll withdraw 4% of the account the first year and increase that by 3% each succeeding year.
The spreadsheet shows Max will pay an income tax of $14,375 on the conversion. The spreadsheet assumes the taxes are paid with resources outside the IRA. If there’s no conversion, this “side account” is retained and invested. So, if Max doesn’t do a conversion he has both the traditional IRA and the money he would have used to pay taxes on the conversion.
By age 70, the Roth IRA has compounded to $114,423. But if there had been no conversion, the combination of the traditional IRA and the side account would total $142,608. But that’s before taxes. Max has to pay income taxes to take money out of the traditional IRA.
The spreadsheet shows that 30 years after retiring, Max will have taken total after-tax withdrawals of $228,857 whether he does a conversion or not.
But the conversion leaves him better off. After 30 years the after-tax value of the traditional IRA and side account would be only $54,573. The after-tax value of the Roth IRA would be $109,785, a $55,213 advantage for the conversion.
That’s not a big advantage after 30 years. The conversion advantage is more substantial if tax rates increase. If the retirement ordinary income tax rate increases to 31% and blended investment rate increases to 22%, the conversion has a $66,337 advantage 30 years into retirement. The more tax rates increase, the greater the advantage of the conversion.
Investment returns also make a big difference in the results.
Let’s revert back to the original tax rate assumptions. But let’s assume Max is a conversative investor (or the markets enter a period of below-average returns). He expects to earn 6% pre-tax annually before retirement and 4% after retiring.
In that case, the advantage of a conversion declines to only $10,066 after 30 years of retirement. The higher the investment returns, the more sense a conversion makes.
Another important factor is the amount of time money stays undistributed in the Roth IRA after the conversion.
Suppose we go back to all the original assumptions on tax rates and investment returns. But we assume Max doesn’t take any distributions from the Roth IRA until age 75.
After 30 years of retirement, the conversion now has an advantage of $156,302.
That’s one factor that makes an IRA conversion a solid estate planning tool. Max doesn’t have to take distributions from the Roth IRA after doing the conversion. If he has enough income and assets outside the Roth IRA to fund his standard of living, he can leave the Roth IRA as a safety account for him and a tax-free asset to leave to his heirs.
The spreadsheet, or another comprehensive calculator, allows Max to calculate the difference between leaving his heirs a Roth IRA or a traditional IRA plus the side account.
An IRA conversion isn’t for everyone or for every situation. But in the situations in which it’s appropriate, the benefits of a conversion can be substantial. That’s why it’s important to analyze the results under different assumptions and considering all the relevant factors. Don’t try to make this important decision by intuition or by looking at only one or two assumptions. Use one of the many calculators available to estimate the results under the different assumptions.
Also, don’t make a decision about a conversion only one time. Your circumstances, the tax law, and other factors change. Reconsider the decision periodically. It’s especially important to consider a conversion after a sharp decline in the value of a traditional IRA. You essentially can convert at a discount, because the value is lower, and have the gains from the rebound accumulate in the tax-free Roth IRA.