Does The Roth IRA Conversion Make Sense?

Conversion to a Roth IRA may make sense in the following situations:

1.  You expect the IRA to grow and would prefer to pay taxes on the lower current account balance instead of on the expected future amount.

2.  You expect that the post-retirement income tax bracket will be the same or higher than the current one.

3.  You expect to live for a long time after conversion, and do not want to have to take distributions from the IRA if they are not needed.

If the taxpayer is a candidate for conversion, it would also be important to evaluate whether there is enough non-IRA cash on hand to pay the tax associated with the conversion.  If other assets have to be liquidated to pay the tax, the potential tax liability associated with liquidation would have to be factored into the conversion analysis. Please note, in most cases, funds should not be withdrawn from the IRA to pay the income tax on the conversion, especially if the taxpayer is under age 59 ½, due to the 10% pre-mature distribution penalty tax.

Examples: (The examples below are hypothetical examples using fictional characters. Actual individual situations will produce differing results)

You Expect the IRA to Grow

George, age 40, is a successful physician with a traditional IRA balance of $100,000 on January 1, 2010.  Assume also that the contributions and earnings are pre-tax, and that George is in a 35% federal income tax bracket.

George expects his IRA to grow at a rate of 7.2%, roughly doubling in value every ten years. When George reaches age 70, assuming he makes no further contributions to the IRA, it may be worth about $800,000.

If George keeps the traditional IRA, all distributions from the IRA taken at that time will be taxable.  If George takes a lump sum distribution of $800,000 at age 70 and his tax bracket remains 35%, he will have to pay $280,000 in taxes.

On the other hand, if George does a Roth conversion using the same assumptions, the $800,000 balance at age 70 will be available income tax-free.

What is the cost for achieving that result?  George must be prepared to pay $35,000 out-of-pocket (not from the IRA) for the tax liability in 2010 associated with the conversion.

Does it make economic sense for George to convert?  Here’s some simple analysis.

If George keeps all the money in a traditional IRA and withdraws at age70, he’ll net $520,000 based on the assumptions above.

If George converts, he’ll net $800,000 at age 70. However, in the example, it cost him an extra $35,000 in out-of-pocket taxes today to get the $800,000 at age 70.  If we do a future value calculation for the $35,000 expense using a 7.2% interest rate, we come up with $280,000.  That means the net for George at age 70 is $520,000 for conversion.  This is the same dollar amount George netted from the traditional IRA.

Is it fair to assume a 7.2 % return for the $35,000 used to pay for the tax?  Perhaps a lower rate is fairer, because $35,000 invested outside an IRA might be subject to income or other taxes.  If we assume a lower interest rate for the future value analysis of the amount used to pay income taxes, it would make the conversion alternative look better than keeping the traditional IRA.

You Expect Your Tax Bracket to Be Higher in the Future

If George assumes that his own federal income tax rates in the future will be higher than today’s, it makes conversion look more attractive.

For example, assuming the tax rate at retirement is 50% instead of 35%, if George keeps the traditional IRA, George would only be able to keep $400,000 of an $800,000 lump sum distribution at age 70.  However, since his 2010 tax bracket is assumed to be 35%, the income tax cost of conversion is still $35,000, and the value of the conversion option at age 70 is still $520,000.  That increase in the assumed future tax bracket makes conversion look better.

You Want to Defer RMDs

What if George does not want to take any distributions at age 70?  What if he plans to use other resources to support his retirement need?

Distributions from Roth IRAs are not taxable distributions (qualifying distributions) as long as the Roth IRA has been in existence for 5 years and the Roth IRA owner is at least age 59 ½, dies, disabled or first time home (limited to $10,000).

If George keeps the traditional IRA, he must begin taking required minimum distributions (RMDs) when he reaches age 70 ½--whether he needs them or not. When RMDs are taken, George must pay income tax on them.

If George converts to a Roth IRA, no RMDs are required from the Roth at any time during George’s lifetime.   The extra ability to defer distributions until after George’s death— maintaining tax-deferred growth and tax-free access to the Roth IRA’s values—may tip his decision in favor of conversion.

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This material is intended for educational purposes only and is not intended to serve as the basis for any financial or purchasing decisions.

This document is designed to provide general information on the subjects covered. It is not intended to provide specific legal or tax advice. It is strongly recommended that you consult with your tax advisor or attorney.

It is generally preferable that you have funds to pay the taxes due upon conversion from funds outside of the IRA. Before exercising a conversion, please consult with your tax advisor or attorney.

If you elect to take a distribution from your IRA to pay the conversion taxes, please keep mind the potential consequences, such as an assessment of product surrender charges or additional IRS penalties for premature distributions.

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