How To Tell If Converting To a Roth IRA Makes Sense For You

Individuals are permitted to convert their Traditional IRA’s (“TIRA”) to Roth IRA’s if they meet current income limitations set by the IRS.  In 2010 the income limits are removed allowing anyone to convert.  I set out to examine when OR if a client should convert their traditional IRA to a Roth IRA.

Facts:

1)  Individuals converting to Roth IRA’s must add the amount of conversion to their income and pay federal and state taxes on the converted amount at their highest marginal tax rates.

2)  For any conversions in 2010, tax liability can be spread equally over the 2011 and 2012 tax year.

3)  Conversions are designed to be tax neutral.  If client’s IRA assets are invested the same way in either a Traditional or Roth IRA, and marginal tax rates are the same, then after-tax income is the same for either IRA account.  See example:

TIRA v. Roth IRA Tax

Rate

Deposit

Avg Growth Rate Balance in 20 Yrs After-tax Balance
Roth IRA 32% $6,800 8% $31,695 $31,695
Deductible TIRA

32%

$10,000

8%

$46,610

$31,695

4)  Higher or lower after-tax spendable income only occurs if future tax rates are different from current tax rates.  For example, if future marginal tax rates are higher, then a Roth IRA would produce more after-tax income.

5)  Roth IRA’s are NOT subject to required minimum distributions.

Analysis:

•  Client who has 2 assets – TIRA and Brokerage account (assumes 1.3% return loss to income taxes on the brokerage account – 70/30 portfolio):

TIRA v. Roth IRA

Tax

Rate

Deposit

After-tax Growth Rate

Balance in 20 Yrs

After-tax Balance

TIRA 50% $100,000 8.0% $466,096 $233,048
Brokerage 50% $50,000 6.7% $182,919 $155,481
Total TIRA/

Brokerage

$150,000

$649,015

$388,529

Roth IRA 50% $100,000 8.0% $466,096 $466,096

While I cannot say there are hard or fast rules on when or if to convert an existing traditional IRA, below are some situations where the decision becomes easier to make:

YES – Convert

•  For clients with after-tax investments, who are in a high marginal tax bracket and will be in a high marginal tax bracket during retirement;

•  Clients who are subject to estate taxes;

•  Clients who wish to avoid RMD’s for their beneficiaries and future generations.

NO – Don’t Convert:

•  Anyone who has to pay the tax with existing IRA assets (no brokerage or savings);

•  Clients in retirement living off their IRA money;

•  Clients who are sure to be in a lower tax bracket at retirement.

About the author

Anthony Farella, CFP®

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