Money Matters: Should you convert your traditional IRA to a Roth?

Nobody likes to pay taxes before they have to and with good reason. Deferral is a powerful tool. But sometimes it makes sense to pay sooner. Converting a traditional IRA to a Roth can be one of those times. When you do this, you have to pay the taxes on the current account balance—taxes that would otherwise be deferred until you withdraw the money. But once you convert, you’re eligible to make tax-free withdrawals anytime after age 59½, so long as the money has been in the account for at least five years. 

Whether conversion makes sense depends largely on three variables: your present and future tax rates, your time horizon, and your investment returns. The decision can be remarkably simple or achingly complex.

To begin with the simplest: if you convert a traditional IRA to a Roth and pay the taxes from the account, the only thing that really matters is what your tax rate will be in the future. If your tax rate will be higher than it is now, you win. If it will be lower, you lose. If it will stay the same, you come out even.

Say you have $100 in a traditional IRA and are in the 50 percent tax bracket forever. If you convert, you’ll spend $50 on the tax now and be left with $50 that is free of future tax obligation. If the money is invested and doubles, you‘ll have $100 all to yourself. If you don’t convert and the value doubles, you’ll have $200, but since you’ll still be in the 50 percent tax bracket, your net will remain $100. If your tax rate falls to 40 percent, you will have been better off not converting and collecting $120 after tax. If it rises to 60 percent, not converting would leave you with only $80. 

The complexity builds when you pay the taxes from outside the IRA, which generally is beneficial. In doing so, you take ownership of the entire sum in the account and all future earnings. Let’s again assume you’re in a 50 percent tax bracket and that your IRA holds $100. True, by paying the tax with non-IRA funds, you give up $50 and whatever future earnings that money might have produced. But here’s the thing: if you’d kept that $50, you would have owed some taxes on future interest, dividends, and capital gains anyway. By converting, you’ve essentially swapped a $50 investment whose earnings would have been taxable for a $50 investment that will now grow tax-free.

If you do that, you win even if your tax rate stays the same (other things being equal, of course). It is even possible to win if your tax rate declines, but here the devil is in the details. How much lower will your (or your heirs’) tax rate be? How long will it be before you (or they) withdraw the money? What are the projected investment returns, and how will they be taxed? The permutations are virtually endless, so you’d be wise to consult an advisor who knows the nuances and can coordinate with your accountant and possibly your estate attorney.

The best candidates for Roth conversions are generally people who are temporarily in a lower tax bracket—early retirees, for example, who aren’t yet taking required distributions from their IRAs and don’t have a lot of ordinary income from their taxable accounts. In such a situation, one potential key decision is whether to make one large conversion or a series of smaller ones. 

Since the conversion advantage can compound over time, it also helps if you won’t need the money and can pass the IRA on to your heirs. In that case, the relevant tax rates would be what you pay on conversion versus what they will pay when they take the money out. Regardless of who’s paying, don’t forget state tax rates.

The conversion decision would be easier if not for the nuances of tax law. People in otherwise similar ­situations could come to different conclusions simply by living in different states—the difference in state taxes can mean the difference between being subject to the Alternative Minimum Tax or not. Similarly, be sure to ask your advisors about the impact of the Medicare surcharge as well as phase-outs on itemized deductions and exemptions. 

If the numbers in the Roth analysis are close, keep in mind that conversions do offer other potential benefits. One is that Roth IRAs aren’t subject to required minimum distributions during the account owner’s lifetime, potentially providing flexibility. Another is that converting might ultimately reduce the size of your taxable estate.

Keep in mind that your decision could be affected by future changes in tax law, beyond just the tax rates themselves. For example, what if non-spouse beneficiaries were not allowed to take distributions from inherited IRAs over their lifetimes but instead had to distribute the entire balance over five years? That could work against the Roth—as noted above, time is generally an ally when it comes to conversions. On the other hand, in the case of very large IRAs, it could work in favor of a conversion because the higher distributions from a traditional IRA could bump a beneficiary into a higher bracket. Whether that changes the decision depends not only on your unique ­circumstances but on your read of the political landscape.  

 

---

REASONS TO CONVERT—OR NOT

Consider converting to a Roth if…

• You’re temporarily in a low tax bracket.

• You can pay the taxes with funds from outside the IRA.

• You have substantial non-IRA assets to draw on so that the converted assets will have ample time to benefit from tax-free compounding.

• You won’t need the money and can pass it on to heirs.

• Your heirs’ projected tax bracket will not be substantially lower than yours.

• You’re in a position to benefit from an estate-tax standpoint.

Consider sticking with your traditional IRA if…

• You’d need to use funds in the IRA to pay the taxes.

• You’d need to draw upon the account before the converted assets would have sufficient time to benefit from tax-free compounding.

• You might be leaving assets to children in a low bracket.

• You (or your heirs) expect to spend the future in a state with much lower tax rates than you would pay on a conversion. 

---

Paul Palazzo, a Certified Financial Planner, is the managing director at New York-based Altfest Personal Wealth Management.