Roth IRAs: Do the Math Before Deciding to Convert
Despite hype, not everyone benefits. The biggest winners: the young and the wealthy.
July 2, 2010
Should I or shouldn’t I? That’s a question many Americans are facing as they ponder whether to convert their traditional individual retirement accounts to a Roth IRA.
The reason for the all this IRA angst? Starting in 2010, income limits that prevented high-income earners from converting to a Roth are gone. And while Roth conversions trigger a big up-front tax bill, those converting in 2010 will be able to spread the taxes over a two-year period.
The advantage of the Roth is twofold. Money withdrawn from a Roth IRA is generally free of taxes, unlike a traditional IRA where distributions are taxed as regular income. Moreover, Roths don’t require annual minimum distributions, which force traditional IRA holders to begin withdrawing money at age 70.5.
A Boon for Some, Worthless for Many
“People fall in love with the idea of never paying income tax,” says Stephen Bigge, who runs the Roth conversion calculations for accounting firm Baker Tilly Virchow Krause, LLP in Appleton, Wisc. But, he says, it’s tough to understand the actual benefit of converting without crunching the numbers. After running thousands of calculations, Bigge’s conclusion: Although Roth conversions can be a real boon to some, they turn out to offer little or no benefit to many.
“It isn’t a slam dunk by any means,” says Bigge, noting that the tax bill created by moving the money out of the traditional IRA is a formidable hurdle.
Meet John Doe
Take the case of 73-year-old John Doe, a widower with a $1 million portfolio. About half his money is in a traditional IRA; the rest is in a taxable portfolio of stocks and bonds. He expects to live to be 100, since longevity runs in his family, and he doesn’t want to outlive his money. Should he convert?
That depends. Plug in some basic assumptions, including annual living expenses of $60,000, federal income tax rates rising to 28 percent from the current 26 percent in his bracket, a capital gains tax increase to 20 percent from the current 15 percent, and a 4 percent annual inflation rate—admittedly conservative but reflecting the importance of health care costs in retirement. Then factor in Social Security benefits, a small pension, a 6 percent annual return on investments and a $196,000 income tax bill created by the conversion.
Using these assumptions, a Roth conversion give John a slight advantage, but only after he hit age 94. At that point, he’d be ahead by about $35,000. With either a traditional IRA or a Roth, however, he’d deplete all his assets before reaching age 100—the Roth would get him to 97 while the traditional IRA would only last until age 96.
But what happens if the key variables change? A more modest rate of inflation, lower living costs, higher tax rates or a better rate of return would certainly boost the Roth’s benefit. With a 9.2 percent annual return, for example, John no longer runs out of money at age 100 and actually has $800,000 more than he would if he hadn’t converted. But he still doesn’t break even until age 90.
The reason the Roth doesn’t offer a bigger benefit: John needs his Roth money to pay the bills, so he’s spending down those assets faster than they can grow. For a conversion to be advantageous, the Roth needs to grow untouched for a long time to make up for the big bite that the initial tax bill takes out of total assets. In John’s case, the $196,000 tax—taken from his taxable accounts—will reduce his total assets by close to 20 percent. After that, it takes roughly 20 years for him to break even, even under the higher-return scenario. And if John needed to use IRA money to pay the initial taxes, the numbers would be far worse.
Winners: The Young and the Wealthy
Those best able to clear that tax hurdle are the young and the wealthy. People with enough money in non-Roth accounts may never need to tap their Roth assets. As such, the Roth can be used as an efficient estate planning tool, providing heirs with a great source of income-tax-free money. Although inherited Roths are subject to annual minimum distribution requirements, those distributions are spread over the inheritor’s lifetime. Leave a Roth to a 16-year-old, for example, and the account will have a 67-year payout.
Those subject to the estate tax will also likely find a Roth conversion advantageous, since current tax laws end up penalizing the estates of people who die with assets upon which income tax is still owed.
And those who make the conversion when they are relatively young are more likely to let their Roths grow untouched for multiple decades. “It works perfectly with people who are younger,” says Beth Gamel, a fee-only financial planner with Pillar Financial Advisors, Waltham, Mass., noting that these people are also more likely to live past their break-even point.
If John were 45 years old, for example, converting to a Roth would make a significant difference. He’d still deplete his taxable accounts at age 85—which would also be his break-even point—but by that time he’d have more than $5 million in his Roth. The difference between converting and not converting in this scenario: just over $3 million at age 100.
Run the Numbers
There are lots of online calculators designed to help IRA owners with the conversion decision, but most can’t accommodate the full range of variables that can affect a Roth conversion. Given the potential impact of each variable, it makes sense to get a detailed analysis from a professional before making a decision.
Nonetheless, there’s one scenario where it doesn’t makes sense to convert? If you’re leaving all your money to charity, Gamel notes, you’ve already eliminated those onerous income taxes.