Effective January 1, 2010, for the first time in history, individuals with a household income exceeding $100,000 will be able to convert their traditional IRA assets to a Roth IRA. Many upper-income taxpayers believe that tax rates are going to be increasing in the future, thus they are very interested in exploring a Roth IRA conversion.
In doing a conversion, the IRA owner is choosing to pay taxes now on the existing balance of the IRA to avoid paying taxes on that balance later. Additionally, as long as the owner keeps the money in the Roth IRA for at least five years and does not withdraw interest and gains until after age 59½, the owner avoids income taxes altogether on future growth of the Roth IRA.
So, the fundamental question the owner asks us as salespeople is, "Is it better for me to pay the taxes now or later?"
At this point, a word of caution is necessary. Unless you are properly qualified and licensed to provide tax advice, you should refer your client to a tax advisor. But, you may be interested, for your own benefit, in how the question will be answered.
To answer this question for you, there are many Roth IRA calculators on the market, and surprisingly, they vary quite a bit from one another. Some ask for only a few inputs, while some require extensive information to be inputted. Some output a page or two, and some have printouts numbering a dozen pages or more.
What is an agent to make of all this? Are the simple calculators missing an important part of the analysis? Do the complex calculators create a more accurate analysis, or are they overcomplicating things simply to appear more sophisticated?
Let me demystify the analysis for you, because once you understand a few key principles, you will better understand what goes into, and what should come out of, a Roth IRA conversion calculator.
The major rule of thumb to understand is this: If you expect your marginal income tax rate to increase between today and the time when you will be taking withdrawals from your IRA, you would rather pay taxes today. Conversely, if you expect your marginal income tax rate to decrease, you would rather delay the payment of taxes.
Thus, the single most important assumption in any Roth IRA conversion analysis is the IRA owner's belief as to whether the tax rate he is subject to will increase or decrease over time. Of course, no one can know for certain what future tax rates will be, and quite often, one can't be sure of what his future income level will be, either. As a result, the most important assumption in the analysis is also one that is based more on a gut feeling or belief than one based on any precise analysis.
Keep in mind, however, that this rule of thumb is the major reason most advisors would caution against anyone younger than age 59½ undertaking a conversion if he needed to withdraw money from the IRA to pay the taxes due upon conversion. Any amount withdrawn from the IRA prior to age 59½, even a withdrawal intended to be used to pay income taxes, is subject to a 10 percent penalty tax, in addition to ordinary income taxes. Thus, for your client to benefit in this scenario, the tax rate he pays would need to increase by more than 10 percent.
Let's suppose that your client has no opinion on the direction the tax rate he pays will change, or he expects it not to change. In that case, a secondary rule of thumb which can have a lesser, yet nonetheless significant effect on the analysis, is this: If you expect your marginal income tax rate to stay essentially the same in the future, making a Roth IRA conversion could be advantageous if you pay the taxes due upon conversion from funds held in a taxable account, or if your IRA includes non-deductible contributions. This is because you would be moving post-tax money whose future earnings are taxed to a situation where the future earnings are potentially not taxed.
Let's start with the situation where you have non-deductible contributions in your IRA. In this situation, if you were to keep the money in a traditional IRA, you would ultimately be able to withdraw the non-deductible contributions tax-free, but you would owe taxes on the earnings generated by that money. Alternatively, if you did a Roth conversion, there would be no tax due upon conversion on the non-deductible contributions, you would still be able to withdraw the non-deductible contributions tax-free, and if you followed the 5-year and age 59½ rules, you would not owe taxes on the earnings generated by that money. So, you can see the advantage of the Roth IRA conversion.
The logic is similar when you are using funds held in a taxable account to pay the taxes due upon conversion. Suppose that your traditional IRA and your taxable account are both growing at the same rate of interest and gains. In this case, the deferred taxes are growing at that rate of interest and gains, but the taxable account is growing at that rate of interest and gains less taxes. If you do a Roth IRA conversion, you eliminate the taxes going forward, so you eliminate the effect that the future taxes would have on dragging down the after-tax growth of the taxable account.
So, in summary, the analysis as to whether a Roth IRA conversion is advantageous comes down to two questions:
1. Do you expect your marginal income tax rate to change dramatically between today and when you will be taking withdrawals from your IRA?
- If you think your tax rate will increase, the Roth IRA conversion is advantageous.
- If you think your tax rate will decrease, stick with the traditional IRA.
- If you think your tax rate will stay about the same, go to question No. 2.
- If you would need to withdraw money from your IRA to pay the taxes due upon conversion and you are under age 59½, then when you are answering this question, increase your current marginal income tax rate by 10 percent.
2. If you expect your marginal income tax rate to stay about the same in the future, then does your IRA include non-deductible contributions, or would you be able to pay the taxes due upon conversion from funds held in a taxable account?
- If yes, the Roth IRA conversion is advantageous.
- If no, stick with the traditional IRA.
That's really about all there is to the analysis. As long as your Roth IRA conversion calculator is asking you these questions, then you can have confidence it is reliable. I have seen very simple calculators that consider these issues, and I have seen complex calculators that do not.
So, don't make your decision on which calculator to use based on whether it seems simple or sophisticated. The above questions lead you to the right conclusion. All a Roth IRA conversion calculator does is help you back it up with numbers.
The information provided here has been taken from third party sources and is deemed to be reliable, but is not guaranteed. It is provided for informational purposes only, and you should consult with a tax advisor for further information. Neither Chris Conklin nor Insurance Insight Group provides tax advice. No party assumes liability for any loss or damage resulting from errors or omissions in the use of this material.
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