The Roth IRA is one of the most powerful instruments for tax and old-age provision, but it is misunderstood and often misused. Many financial advisors have identified 2020 as the best time to convert all or part of an IRA. Income taxes and the cost of converting an IRA could never be lower in the future than they were in 2020 and 2021. The tax cuts under the Tax Cuts and Employment Act are expected to return to their previous levels after 2025. They could rise sooner if Congress decides it needs more money to pay its expenses.
The investment income in a Roth IRA compound is tax free, and most Roth IRA distributions are tax free. Additionally, no minimum distributions (RMDs) are required during the life of the original owner. Distributions are also tax exempt for beneficiaries who inherit a Roth IRA. However, most beneficiaries are required to empty the Roth IRA within 10 years of their inheritance, according to the rules set out in the SECURE Act. See this month’s Estate Watch article.
In contrast to a conventional IRA, the benefits of a Roth IRA are reloaded. You will not receive a deduction for contributions to a Roth IRA, but will have to make your contribution with money on which you have already paid income tax.
Most of the contributions to the Roth IRA are made by converting a traditional IRA into a Roth IRA.
However, you need to include the amount you convert into gross income as if it had been distributed to you. That is, you pay income tax on the converted amount.
Many people hesitate to convert an IRA because they are unsure whether it will pay off in the long run. They don’t like paying taxes now instead of in the future. Also, too many people try to make a conversion decision based on intuition or just a few factors.
A number of factors will determine whether a conversion will increase after-tax wealth over time. This is why I created my IRA conversion table. It’s an Excel spreadsheet that you can use to modify many different factors and compare the results of a move to the status quo under different assumptions about tax rates, investment returns, holding periods, the converted amount, the delay in withdrawals and much more.
Let us consider the hypothetical case of Max Profits. He has a large IRA and is considering converting $ 50,000 this year when he turns 60.
Max initially assumes that he will have an 8% pre-tax return on investment in his early retirement years and a 6% return on retirement. Its ordinary effective income tax rate now and at retirement is 28.75%. Max estimates that the effective tax rate, both before and during retirement, on his taxable investments will be 19.25% after combining long-term capital gains, short-term capital gains, qualifying dividend income, and interest income.
Max expects to start making payouts from the IRA at age 70. He will withdraw 4% of the account in the first year and increase it by 3% every following year.
The table shows that Max will pay an income tax of $ 14,375 on the conversion. The table assumes that taxes are paid with resources outside the IRA. If no conversion takes place, this “secondary account” is retained and created. 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 the age of 70, the Roth IRA has increased to $ 114,423. However, if there had been no conversion, the combination of the traditional IRA and the minor account would total $ 142,608. But that’s before taxes. Max has to pay income taxes to get money out of the traditional IRA.
The table shows that 30 years after his retirement, Max has withdrawn a total of $ 228,857 after tax, regardless of whether or not he makes a switch.
But conversion leaves him better off. After 30 years, the after-tax value of the traditional IRA and subsidiary account would be only $ 54,573. The after-tax value of the Roth IRA would be $ 109,785, a benefit of $ 55,213 for conversion.
That’s not a big advantage after 30 years. The conversion advantage is greater with increasing tax rates. If the normal retirement income tax rate increases to 31% and the mixed investment rate increases to 22%, the conversion has a benefit of $ 66,337 30 years after retirement. The more tax rates rise, the greater the benefit of the changeover.
Investment returns also make a big difference in results.
Let’s go back to the original tax rate assumptions. However, let’s say Max is a talkative investor (or the markets are entering a period of sub-par returns). He expects to earn 6% pre-tax annually before retirement and 4% after retirement.
In this case, the benefit of converting after 30 years of retirement is reduced to just $ 10,066. The higher the return on investment, the more sensible a change is.
Another important factor is how much time money is not distributed in the Roth IRA after the switch.
For example, let’s go back to all of the original tax rates and investment returns. However, we assume that Max will not take distributions from the Roth IRA until he is 75 years old.
After 30 years of retirement, the conversion now has a benefit of $ 156,302.
This is one factor that makes an IRA conversion a solid estate planning tool. Max doesn’t have to take any distributions from the Roth IRA after the conversion. If he has enough income and assets outside of the Roth IRA to finance his standard of living, he can leave the Roth IRA as a security account for him and as tax-free assets for his heirs.
The spreadsheet or other comprehensive calculator allows Max to calculate the difference between leaving a Roth IRA or a traditional IRA plus the subsidiary account with his heirs.
An IRA conversion is not for everyone or for every situation. In those situations where it is appropriate, the benefits of conversion can be significant. It is therefore important to analyze the results under various assumptions and to consider all relevant factors. Don’t try to make this important decision through intuition or just an assumption or two. Use one of the many calculators available to estimate the results under the various assumptions.
Also, don’t make a one-off decision about a conversion. Your circumstances, tax law, and other factors will change. Reconsider the decision regularly. It is especially important to consider migrating after a traditional IRA has suffered severe depreciation. You can essentially convert at a discount as the value is lower and the profits from the rebound accumulate in the tax-free Roth IRA.