Roth IRA conversions: Do they make sense?Article added by Roccy DeFrancesco on February 17, 2009
Roccy Defrancesco

Roccy DeFrancesco

MI

Joined: May 24, 2006

So, what is a Roth IRA conversion? It's simply when you convert a traditional tax-deferred IRA to a Roth IRA where, once converted, the money is allowed to grow tax-free and come out tax-free. Income taxes are due on all of the money in the IRA at the time of conversion. If you convert before age 59.5, the normal 10-percent penalty for early withdrawal is waived as long as you wait five years before taking money out of the new Roth IRA and are over age 59.5 when taking withdrawals.

Should clients convert traditional IRAs to Roth IRAs?

Wouldn't you know it? The answer is: it depends. What does it depend on? More variables than you can shake a stick at, as they say.

I had no idea before creating my own Roth conversion calculator how the numbers would turn out. The numbers even shocked me and reminded me that many times free calculators on the Internet are free for a reason.

Let me make the general statement that, if your clients are in the same or lower tax bracket when in retirement, converting to a Roth IRA is not going to make economic sense for most of them.

Don't believe me? No problem! I'll simply give you the math, and you can decide for yourself if the numbers are accurate.

Variables

The problem with the online calculators I found were in the assumptions/variables they used. Most used far too few or incorrect variables, which makes them woefully inaccurate. The variables I used in my calculator are numerous, and would take up too much space in this newsletter to give them to you and explain why they need to be used.

Examples

I figured the best way to get the point across is with examples. For the examples, I will convert a $500,000 IRA. The numbers by percentage (meaning a percentage good or a percentage bad) won't change if your clients have less or more in their IRAs. In addition, I used a 1.2 percent average mutual fund expense on the money in the IRA and a 7-percent annual rate of return. I will have the clients take income at age 70 for 15 years. I assumed the clients file taxes as married, filing jointly, and live in a state with no income tax.

1) Paying taxes from the IRA -- these are clients who think they are candidates to convert their IRA but don't have the needed money to pay the income taxes upon conversion.

Current AnnualTaxes due atWithdrawal fromWithdrawal fromPercentage
AgeIncomeConversionNon-Roth IRARoth IRADifference
65$125,000$165,487$47,748$35,218-26.24%
60$125,000$165,487$63,297$46,687-26.24%
55$125,000$165,487$83,910$61,890-26.24%
50$125,000$165,487$111,235$82,045-26.24%
Current AnnualTaxes due atWithdrawal fromWithdrawal fromPercentage
AgeIncomeConversionNon-Roth IRARoth IRADifference
65$75,000$160,487$47,748$36,077-24.44%
60$75,000$160,487$63,297$47,826-24.44%
55$75,000$160,487$83,910$63,401-24.44%
50$75,000$160,487$111,235$84,047-24.44%


The above charts make it clear that if your clients are planning to use the money from their IRA to pay the income taxes for the conversion, it's going to make little sense to convert. I assumed the clients would be in the same income tax bracket in retirement. If the clients are in a lower income tax bracket, they will get more money from the non-Roth IRA and the same from the Roth and, if in a higher tax bracket, less from the non-Roth IRA and the same from the Roth.

2) Paying taxes due on conversion from "other" non-IRA sources -- these clients have the needed money lying around to pay the income taxes upon conversion so all of the money upon conversion can stay in the new Roth IRA to grow and come out tax-free.

Current AnnualTaxes due atWithdrawal fromWithdrawal fromPercentage
AgeIncomeConversionNon-Roth IRARoth IRADifference
65$125,000$165,487$66,401$63,664-4.12%
60$125,000$165,487$86,689$84,369-2.68%
55$125,000$165,487$113,267$111,880-1.22%
50$125,000$165,487$148,066$148,3140.17%


The following is if the clients had to sell stock with a $50,000 basis to pay the tax and where the mix of long-term and short-term capital gains taxes upon the sale is 50 percent.

Current AnnualTaxes due atWithdrawal fromWithdrawal fromPercentage
AgeIncomeConversionNon-Roth IRARoth IRADifference
65$125,000$165,487$69,827$63,664-8.83%
60$125,000$165,487$90,997$84,369-7.28%
55$125,000$165,487$118,660$111,880-5.71%
50$125,000$165,487$154,831$148,314-4.21%


If the clients in the above chart earned $75,000 a year, the percentage difference at the above ages respectively would be: -7.89 percent, -6.36 percent, -4.82 percent, -3.33 percent.

The following chart shows you what would happen if clients earning $75,000 a year have their income tax bracket go up to 30 percent as the top marginal rate in retirement.

Current AnnualTaxes due atWithdrawal fromWithdrawal fromPercentage
AgeIncomeConversionNon-Roth IRARoth IRADifference
65$75,000$160,487$65,932$63,664-3.44%
60$75,000$160,487$85,884$84,369-1.76%
55$75,000$160,487$111,946$111,880-0.06%
50$75,000$160,487$146,324$148,3141.36%


Explaining some problems with online calculators

The main problem with Internet calculators is that they do not live in the real world. In the real world, some clients will have to sell stock to pay the taxes; and there is a cost to that which must be factored in. Additionally, if clients didn't convert to a Roth, the money used to pay taxes would grow and needs to be added to the amount of after-tax money taken from the non-Roth IRA. Only when you take into account all the needed variables can you have a real-world comparison to determine if converting to a traditional Roth IRA makes sense.

Summary

Fundamentally, I could care less if converting to a Roth IRA makes economic sense. What I try to do is simple. I try to give advisors the most real-world numbers I can come up with in a verifiable and unbiased manner. Am I shocked at the numbers above? Yes.

What do the above numbers mean? They mean that most of the advisors who are discussing Roth conversions are not giving accurate advice.

What do you do now if you want to talk about Roth conversions with your clients? I'm not sure. You may want to pay programmers to create your own calculator, or you may want to get your hands on mine. I am converting my calculator to an online application advisors can use to help run the "real" numbers for their clients.

For sure, you should attend my Webinar where I will be going over Roth conversions so you can learn about all the needed variables and can ask me questions about the numbers.

*For further information, or to contact this author about the aforementioned Webinar, please leave a comment and your e-mail address in the forum below.
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