Is Converting a Traditional IRA to a Roth a Brilliant or Stupid Idea Right Now?

If you are over 70 ½ you might consider converting your Traditional IRA to a ROTH IRA right now. If so, you’ve got plenty of good reasons to think about it.

First, the market has done a number on your IRA account value. Since you must pay ordinary income tax on any amount you convert, low values mean lower taxes.  A good thing.

As an added bonus, Congress passed a law in December of 2008 lifting the requirement to take distributions from your IRA (for 2009 only). So if you don’t take your RMD (required minimum distribution) you will have lower taxable income.  That means it’s easier to qualify for the conversion (your AGI must be less than $100,000 to convert). It also means the tax on the conversion might be lower.

So the stars are all aligned…but does that mean you should convert your Traditional IRA to a ROTH?

The answer to this question really depends on your unique situation.  It also depends on your ultimate goal. If your main goal is to accumulate wealth, this might indeed be the time to convert. I ran some numbers and concluded that (for the right person) it makes sense to convert.

Here is what I assumed:

1. You have $100,000 in an IRA and $35,000 in cash.

2. You are in the 35% tax bracket.

3. If you convert, you will use the cash to pay the tax due.

4. You can earn 5% on your money in the IRA.

5. You also earn 5% on the cash but since it’s in a taxable account, your net earnings are reduced to 3.25%. (I know you can’t earn 5% on cash right now.  I’m using 5% so we can compare apples to apples and also because this illustration is for 20 years plus. You never know where interests rates are going to be a year from now….do you?)

6. You are currently 70 ½ and you if you decide to keep the Traditional IRA as is, you will take out just the RMD amount and deposit that into your savings account.

Let’s consider the Roth Conversion first. It’s simple.  We use the $35,000 to pay the 35% tax on the conversion so it’s gone.  The Roth continues to grow at 5%.  At the end of 20 years, the value of this account is a cool $265k.  NICE.

rothtablever1

Now consider the alternative.  Let’s say we don’t convert our Traditional IRA.  Look at the chart below.

rothtabletwo

Column B shows “IRA VALUE” growing at 5%. It’s reduced by the amount you withdraw to satisfy the RMD (column D).

Column C shows the RMD factor.  This is simply the number the government makes you use to determine the amount of your RMD.  For example, in year 1, the factor is 27.4.  You divide the balance – in this case $105,000 by 27.4 and arrive at an RMD of $3832.  This is the amount you must take out in the first year – unless it’s 2009 of course.

The cash is shown in column E.  You deposit your RMD (net of tax) into that account and this, plus the prior total grows by 3.25%.

After 20 years, the total is $266,191.  So you should definitely NOT convert….right?

Not so fast……

Remember that you’ve paid the tax on the ROTH conversion and you haven’t on the Traditional IRA. If you were to take all the money out of the Traditional IRA, you have to pay that tax.

Again, if you want to approach this question from the standpoint of capital accumulation, you have to look at how much money you’d have if you took all the money out of the Traditional IRA and paid your tax.

Now, truth be told, you don’t really know when you’ll pay that tax.  You could die & your grandchildren could inherit your traditional IRA and they could defer most of the tax for a very long time.

The only way to decide what to do is by making certain assumptions.

As you can see from the graph below, if you don’t need the money and don’t think you’ll ever need the money, the Roth is a good choice.  Again, this is only if you approach the question from a wealth accumulation point of view.  If you are looking at income, it’s a whole other ball game.

You can see, even if you don’t consider the latent tax liability, you’ll have more wealth in year 23 if you convert to the ROTH.

rothtablethree

Bottom line?  This calculation assumes that you have money outside of your Traditional IRA and can use that to pay the tax on your conversion. If you find yourself in that situation and your main objective is to grow your wealth – rather than create retirement income – the conversion could be for you.

But I think there is a more important take-away. Never listen to anyone who makes a blanket statement about converting your IRA or not.  There are too many variables and assumptions. The right answer depends on what you want to do with your money.  It’s just stupid to think that one solution fits everyone. For example, if you told me that your main goal was to maximize retirement income, my answer might be completely different.

Have you converted your IRA into a Roth?  Are you considering doing so? Have I missed something that you think is critical in making the decision?

This was a guest post by Neal Frankle, CFP. Neal is an author and avid blogger. Subscribe to his blog at www.wealthpilgrim.com.

Comments

  1. 20 years down the road one would be 90.5 yrs old – well over the average life expectancy. So that’s a consideration also. I looked at the 10 year rates for comparison instead. And while I am planning on 103 myself (or at least late 90′s which is what the family seems to run), not everyone is gonna live that long.

    So yes – depends on whether you are just building wealth and want some to pass along to heirs, or want to spend freely in your old age. I’m just going to take from your article that there is no pat answer to this question – and remember that part. Thanks for doing the math for us :)

  2. Another really important point to consider here is the upcoming Roth IRA change in 2010 that would allow you to pay the tax on conversion over two years – 2011 and 2012. Basically deferring half the tax a full year and the other half 2 years.

    The 2010 change will also allow people with over $100k in Modified AGI to convert, something that’s not available now.

  3. I think the best advice to give on this subject is that you need to be very careful about any decision you make. BTW – why would someone in the 35% tax bracket have only $100k in an IRA?

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