By John “Jack” F. Kiley, CPA, CISP
Managing Partner / MidAtlantic IRA, LLC
Periodically, the question arises of whether to convert a Traditional IRA to a Roth IRA. Generally clients must ‘crunch the numbers’ to decide whether this makes financial sense. As with most tax calculations, there is no hard and fast rule for everyone. Several factors need to be considered. Some are easy to determine (your age, ability to pay the tax without retirement funds) and others are not so easy (rate of return on investments and effective tax rate in retirement).
First it helps to understand the process. Basically what happens is that you call your IRA custodian and tell him that you want to convert your Traditional IRA to a Roth IRA. The custodian then closes your Traditional IRA account and opens a Roth IRA account for you. Then, at year end, he sends you a 1099R which tells you (and the IRS) the fair market value of the account at the time of conversion. The bad news for you is that you must include this amount with your other income for the year and pay tax on it as if you took the money out of the account. This has the effect of putting these funds in the position of being Roth contributions (Roth contributions are not deductible when they are made).
The big question to consider is why would you want to do this anyway? The biggest reason is that Roth earnings are never taxed. Generally speaking, when you make contributions to or convert Traditional IRAs to Roth accounts, you pay tax on these funds. Assuming the account is open for five years, when you take distributions, there is no tax. In other words, you pay no tax on the earnings on the assets in the Roth. The other big advantage is that Roth IRAs are not subject to required minimum distributions. When an account holder reaches the age of 70 ½, he must start to take distributions from a Traditional IRA. This is not the case with Roth IRAs. This allows for the longest possible build up of tax free income. Generally speaking, your goal is to accumulate assets during your productive (working) years. In retirement, you start to draw down these assets. From a tax efficiency standpoint, you want to deplete your taxable resources first (savings accounts, CDs, personal portfolios) and your tax advantaged resources last (retirement plans and IRAs). This provides for the longest possible build up assets because you are not paying current tax on the on the assets in your tax deferred accounts. Next you need to make some assumptions and run the numbers. You want to compare the build-up in and distribution from your account as if it were Traditional IRA and as if it were a Roth IRA.
Let’s look at the build up phase. In a spreadsheet calculate the growth of your account from now until the point where you will start to distribute funds. To do this you need to know the value of your account now, how many years until retirement (this may not be age 65), and you’ll need an average rate of growth. Generally speaking, the younger you are at the time of conversion, the better Roth looks. This is because you have more time to ‘recoup’ the tax AND build up the earnings in the account. Also, the higher you think your rate of return on your investments will be, the more attractive converting will seem. There are two wrinkles in this phase. First, in the Traditional IRA, you’ll need to consider the tax savings on any deductible contributions made during this phase (you make a $5,500 contribution and you’re in the 28% tax bracket. Your tax savings would be $1,540). In converting to a Roth IRA, you’ll need to consider the tax paid.
During the distribution phase, you need to look into the crystal ball and decide what you think tax rates will be. Remember, not only to calculate the tax you’ll pay on the Traditional disbursements, but also the tax savings on the Roth distributions. Keep in mind that with Traditional IRAs, you must start to draw the money out (and pay tax) when you reach age 70 ½ –even if you do not need the cash flow. This is not the case with Roth IRAs, so depending on the returns and value of your personal portfolio (non IRA investments), your ‘Traditional distribution schedule’ and your ‘Roth distribution schedule’ may look very different. Also, don’t fall into the trap of thinking that your tax bracket will be significantly lower in retirement. Statistically, most people need 70% of their pre-retirement earnings during their golden years. This may keep you in the same (or higher) tax bracket. Generally speaking, lower future rates will favor not converting and higher future rates favor converting.
Once you combine the two phases it should be easy to determine if you are better off paying the tax man now (converting) or paying later. Analyzing whether to convert to Roth will require you to make some assumptions. By developing a spreadsheet based on the above you can change the assumptions to figure out, for example, what is the rate of return where conversion starts to look attractive. One last point you may want to consider is the value of the investments in your IRA. For example, let’s say you own a rental property in your IRA with a current fair market value of $100,000 and you plan to hold onto the investment long term. Further, you think that the market in undervalued by say $50,000. If you convert and pay the tax on the FMV of $100,000 and your assessment of the market is correct, you will not pay tax on the $50,000 –ever!