The Simple Tax Math Of Roth Conversions

By Rich White AAA

Affluent individuals have an opportunity to participate in Roth IRA conversion for the first time in 2010. The current modified adjusted gross income (MAGI) limit of $100,000, above which conversions are not allowed, is scheduled to expire at the end of 2009. Starting in 2010, everyone will have an opportunity to convert to a Roth, without regard to income. Here we'll cover these changes and show you how to calculate whether a Roth conversion will benefit you. (For related reading, see Did Your Roth IRA Conversion Pass Or Fail?)

What's New?
This tax law change, enacted under the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), also includes a one-year sweetener. On any conversion made in 2010, half of the converted amount may be reported as taxable income in 2011 and the other half in 2012. Normally, converted amounts must be added to taxable income in the year of conversion.

If you are evaluating whether a conversion will make tax sense, you may be tempted to hire a certified public accountant (CPA) to help you do the math. However, in this case, the math may be simpler than you think.

The Concept: Tax-Neutral IRAs
When universal Roth conversions become available in 2010, millions of Americans will have the opportunity to participate in two types of IRAs:

  1. A Traditional IRA, to which pretax money is contributed
  2. A Roth IRA (or Roth conversion), to which post-tax money is contributed.
  3. A Traditional IRA to which post-tax money is contributed. This is not a viable retirement plan choice for many individuals, so this plan won't be discussed here.

Under current law, MAGI thresholds will continue to apply to annual Roth contributions after 2009, but annual contributions to a Roth will become viable for anyone who is not covered by a retirement plan at work and the spouses of such people through the two-step process of:

  1. Contributing pretax money to a Traditional IRA
  2. Converting that account immediately to a Roth

There are important non-tax differences between Traditional and Roth IRAs to consider when choosing between them. However, our focus here is on tax efficiency. Congress has made this comparison simple by creating tax neutrality between the two choices. This means if comparable amounts are contributed/converted, there are comparable investment returns and there are no changes in income tax rates over time, you can expect to have the same amount of after tax money available for retirement in Traditional and Roth IRAs. (For more insight, see Roth Or Traditional IRA...Which Is The Better Choice?)

The concept of tax neutrality seems to contradict a basic investment tenet - namely, that tax deferral has value. If you can put pretax money into a Traditional IRA and postpone paying tax on that money for years, it seems logical that investment returns on this money will produce more retirement assets. But it's not so.

Example - Why Tax Neutrality Works
A pretax dollar in a tax deferred investment will produce the same after-tax future value as a post-tax dollar in a tax-free investment, assuming tax rates stay constant.
To prove this, let\'s consider a numerical example. Suppose that an investor has an opportunity to convert $10,000 to a Roth IRA in 2010. We\'ll assume that the investor pays tax in a combined 32% federal/state income tax bracket and will earn an average investment return of 7% annually over the next 10 years. At the end of that time, the investor will spend whatever money remains after tax.
  • In a Traditional IRA (no conversion) - The $10,000 (hypothetically) will compound tax deferred over 10 years to $19,672. If the full amount is withdrawn and taxed at 32%, the tax will be $6,295. The remainder available to spend will be $13,377.
  • In a Roth IRA (with conversion) - The tax on the conversion (at 32%) will be $3,200, leaving $6,800 to invest. This will compound tax deferred over 10 years to $13,377, which can then be distributed from the Roth IRA tax free.
Figure 1
Copyright © 2008 Investopedia.com
Figure 2
Copyright © 2008 Investopedia.com

Tax neutrality is demonstrated by the fact that the same amount will be available for retirement spending in 10 years from both types of IRAs. The result also would be tax neutral if any other time period or hypothetical rate of return were chosen. It would even be tax neutral if the withdrawals for retirement spending were gradual or systematic, rather than in a lump sum.

Forecasting Your Tax Future
Does tax neutrality mean that there is no tax benefit to evaluate in choosing between a Traditional IRA and a Roth conversion? Far from it!

In fact, tax neutrality helps to focus your IRA decision on the one critical variable that is likely to change in the future: the effective marginal income tax rate that you pay.

  • If this rate is the same in the future as today, tax-neutrality prevails.
  • If this rate increases in the future compared to today, a Roth conversion prevails.
  • If this rate decreases in the future, a Traditional IRA prevails.

Upon taking a Roth conversion, a taxpayer locks in the tax obligation on IRA money at tax rates in effect when the conversion occurs, thus removing future uncertainty about whether they will change. In a Traditional IRA, the ultimate tax burden will depend on the tax rates in effect when withdrawals are taken. The table below uses the same assumptions as the example above while modeling the impact of different future marginal income tax rates.

Marginal Tax Rate in 10 Years, When IRA Withdrawals Are Taken
20% 25% 30% 32% 35% 40% 45%
Traditional IRA Accumulation 19,672 19,672 19,672 19,672 19,672 19,672 19,672
Tax on Withdrawal 3,934 4,918 5,902 6,295 6,885 7,869 8,852
Traditional IRA After Tax 15,738 14,754 13,770 13,377 12,787 11,803 10,820
Roth IRA in 10 Years 13,377 13,377 13,377 13,377 13,377 13,377 13,377
Traditional IRA Advantage 2,361 1,377 393 0 -590 -1,574 -2,557
Advantage as a % of Original Amount ($10,000) 23.6% 13.8% 3.9% 0.0% -5.9% -15.7% -25.6%

Example - The Impact Of Different Future Marginal Income Tax Rates
  • Suppose the taxpayer is in the 25% marginal income tax bracket in 10 years, when an IRA withdrawal is taken. In this case, the tax on the withdrawal would be $4,918, leaving $14,754 after tax. This would be $1,377 more than the disposable income from the Roth conversion, and this difference would represent 13.8% of the original account value.
  • Suppose, however, that a 40% tax rate applies in 10 years. Now, the tax increases to $7,869, leaving $11,803 after tax. This would be $1,574 less than the spendable income from the Roth conversion.

Do you believe tax rates (federal and perhaps state/local) will be higher or lower in the future than they are now? A belief (or fear) that higher rates are in store is one of the best reasons to take advantage of Roth conversions in 2010 or after.

Future Tax Rates
It is beyond the scope of this article to speculate on the probabilities for future tax rates. However, we can mention two pertinent facts:

  1. Federal income tax rate relief originally passed by Congress in 2001 is scheduled to expire at the end of 2010. The table below shows the current income tax brackets and what they will become if tax relief provisions expire on schedule.
Current Federal
Income Tax Rate
Upon Expiration
After 2010
10% 15%
15% 15%
25% 28%
28% 31%
33% 36%
35% 39.6%
Source: Economic Growth and Tax Relief Reconciliation Act of 2001.

Most affluent taxpayers fall into the current 28% federal bracket or above and would be vulnerable to higher rates if tax relief expires on schedule.

  1. Federal tax policies are determined, in part, by the government's ability to balance budgets and avoid large deficits. According to the White House Office of Management and Budget, the U.S. government operated at a deficit in each of the seven fiscal years from 2001 to 2007. The cumulative federal deficit during these years was $1.8 trillion. During the economic expansion of 2003-2007, the deficit increased by $1.3 trillion, to a record $9.2 trillion near the start of 2008.

    Trends in the federal deficit suggest that it may be difficult to avoid future increases in federal income tax rates, especially for affluent and wealthy taxpayers. Future liabilities for federal entitlement programs such as Social Security and Medicare may increase pressures for future tax rate increases. (For more insight, read What Fuels The National Debt?)

Conclusion
In summary, consumers buy insurance against many potential hazards. One way to view the expanding opportunity for Roth conversions starting in 2010 is as a form of insurance against higher income tax rates in the future.

Understanding the basic math of tax neutrality between Traditional and Roth IRAs should help in assessing your personal situation and focusing on the key variable of whether future income tax rates are more likely to rise or fall.

You May Also Like

Related Articles
  1. You need to be patient, diligent and perseverant to be successful at investing, but more importantly, you need to start early.
    Investing Basics

    Why You Should Start Investing Early? ...

  2. Many of us fantasize about winning a big lottery jackpot. Let’s say that actually happened? What would you do with the money? How would you manage it?
    Professionals

    Tips For Managing A Cash Windfall

  3. Retirement

    Planning Ahead for 2015's Tax Law Changes

  4. Even though inflation currently seems tame, it's still the worst enemy of retirees. Here are some tips to reduce its impact.
    Professionals

    Tips For Managing Inflation In Retirement

  5. Retirement

    5 Crucial Tips For Your Retirement Income ...

Trading Center