Roth IRA Conversion: Do They Make Sense?

Roth IRA Conversions? Do They Make Sense?
The Answer Will Shock You!
By: Roccy DeFrancesco, JD, CWPP, CAPP, MMB

IRA Roth Conversion Webinar Click here to listen/view to it on recording

          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% penalty for early withdrawal is waived so long as you wait 5 years before taking money out of the new Roth IRA and are over 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.

            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 several and would take up too much space in this newsletter to give them to you and explain why they need to be used. If you would like to read the list of variables I used to create my calculator and why, you may do so by clicking here.

            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 % good or bad) won’t change if your clients have less or more in their IRAs.  In addition, I used a 1.2% average mutual fund expense on the money in the IRA and a 7% 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 lives 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.

  
            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 laying 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. 

            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%.