There is some shockingly bad advice on the web about converting your traditional IRA to a Roth.The advice typically says that ‘Oh, you will grow your money tax free once it is rolled over, so you will end up with more money’. Even worse are statements like ‘the greater your expected rate of return, the more sense a Roth conversion makes’.
I am not a tax advisor, but I know
When I see it.
It is shocking to hear well respected tax advisors and other who you’d have expected to have take elementary math classes state this. let me disabuse you of this notion by presenting a simple example. But first, some background.
Let’s recap what the two IRA’s are. The traditional IRA, which is what most of us have, pays money in on a pre-tax basis: you have to pay taxes when you withdraw the money at retirement age, presumably when you are in a lower tax bracket than today.
In the Roth, on the other hand, you pay in money post-tax, and the money grows tax free. You can convert the Traditional to the Roth by paying taxes. The big change is that the limits on conversion – you had to earlier make less than a certain income – have been removed. Anyone can convert Traditional to roth by paying appropriate taxes.
For our example, the assumptions we make are
1. Whatever your expected rate of return is does not vary depending on whether it is a traditional or Roth IRA.
2. Your current tax rate and expected tax rate at retirement are the same. Let’s make this 20% (We will expand on this later)
Ok, here is a Math 101 explanation of what does and does not matter:
Let’s say that you have $1000 in your traditional IRA. Your money has grown 400% compounded at the point you withdraw money.
Scenario 1: No Roth
In scenario 1, you choose not to roll it to a Roth. How much money will you have at retirement?
Before taxes, you would have accumulated $1000*4 = $4000. The govt will swoop in and demand that you pay them 20%. So you will end up with $4000 – ($4000*.2) =$3200.
Note this down, kids: You will have $3200 in retirement if you do not roll over to a Roth.
Scenario 2: Roth Conversion
Let’s assume now, under presssure from your tax advisor, who presumably will have a little extra in his paycheck for giving you this advice, gets you to convert to a Roth. Let’s rerun our analysis.
Your tax bill (remember, we fixed our tax rate at 20%) = $1000 * .2 = 200.
Your tax free investment: = $800 (well, minus what you paid your advisor)
At 400% (Tax Free! Yay!) growth you will have: $800 *4 = $3200.
Wait, What? You end up with the same amount??
Yeah. As you learned in middle school, a*b = b*a.
If the expected tax rate at retirement is the same as your current tax rate, it matters not a whit whether you convert to Roth or not. You expected rate of return is irrelevant.
So what are relevant reasons for a Roth conversion?
There are subtleties to be aware of – after all, this is the US tax code.
The most obvious reason, already alluded to above, is the expected tax rate at retirement. if your expected retirement tax rate is going to be higher than your current, by all means, do the conversion – makes sense to pay less now. For many of us, this is not going to be true. Don’t do it if your expected tax rate in the future is going to be lower than your current.
One reason it might make sense to convert part of your traditional to a Roth is because of the withdrawal regulations. at age 70.5, the IRS will take a penalty if you do not make a minimum withdrawal from your traditional. No such thing for the Roth.
Another subtle reason comes from the $200 tax bill that you paid up front for a conversion. If you were not using it for the roth conversion tax bill, you may have invested it – in a taxable account, which is subject to capital gains tax. The $200 will attract additional taxes.