This is the fourth in a series of articles discussing tax rates and Roth conversions. The previous ones (here, here, and here) deal with different aspects of the question of how you determine the relevant rates: the conversion tax rate on the one hand, and the anticipated tax rate on withdrawals, or ATRW, on the other. Now we’re ready to look at the issue of how we use that information when we have it in hand. Some people have reached the mistaken conclusion that a Roth conversion never makes sense if the conversion tax rate is higher than ATRW. In reality this strategy can make sense, but generally only for relatively wealthy individuals. We’ll look first at how the strategy can be a winner for folks with lots of money, and then see how this doesn’t work for the rest of us.
Suppose you’re currently in the highest tax bracket, so a Roth conversion this year would be taxed at 35%. You expect your income to go down somewhat in retirement, so it appears likely that if you don’t convert to a Roth, money you withdraw from your IRA will be taxed at 28%. One way to look at this is that the after-tax value of your IRA is 72% of its nominal value, because the IRS gets 28% of it, including any investment growth between now and whenever you take the money out. From that perspective it may seem unappealing to do a Roth conversion because the 35% tax leaves you with just 65% of its current value.
There’s something else that happens in a Roth conversion, however. If you’re able to pay the conversion tax with money from outside the IRA — money that would otherwise be invested in a taxable account — you end up with a Roth IRA that’s more valuable than the traditional IRA. If the original account held $100,000, it was worth $72,000. The new one (the conversion Roth) is worth $100,000. The account that took a hit was your taxable investment account, which went down by $35,000. So here’s the immediate impact: your unsheltered wealth decreased by $35,000, and your sheltered wealth increased by $28,000.
This short-term effect is undesirable, of course, but now and forevermore you get to earn tax-free investment income on the $28,000 you’ve effectively added to your sheltered wealth. Over the years, $28,000 invested tax-free will eventually catch up with $35,000 you would otherwise have invested in a taxable account. How long this takes depends on assumptions about how fast your investments will grow and what tax rates will apply to that growth. If you play around with numbers on a spreadsheet, you’ll probably find that the break-even point is somewhere around 20 years. For younger folks, and even for older ones who expect to leave their retirement accounts to a younger generation, it’s easy to imagine the account being in existence 30 years or more, and by that point the conversion is highly likely to be a winner, and possibly a huge one, even without taking into account the added benefit of escaping the required minimum distribution rules.
A Roth conversion can be a winning strategy even when the conversion rate is 35% and ATRW is just 25%, because over a longish but not unreasonable period of time, $25,000 invested tax-free can catch up with and pass $35,000 invested in a taxable account. Yet the same cannot be said when the conversion tax rate is 25% and ATRW is 15%. This is probably a fairly common situation for people of moderate wealth, so we should understand why a Roth conversion is unattractive in this situation.
There are two reasons it’s difficult to overcome a differential between 25% and 15%, even though the ten-point difference is the same as when we’re comparing 35% and 25%. The first has to do with the relative sizes of the amounts invested. When someone converts at 35% and anticipates a 25% rate in retirement, the conversion becomes a winner if the money is invested long enough for $25,000 invested tax-free to catch up with $35,000 invested in a taxable account. In this comparison, the taxable account starts out with 40% more money than the $25,000 we’ve added to the Roth. But when we’re dealing with the lower tax rates, we need to invest long enough for $15,000 invested tax-free to catch up with $25,000 in a taxable account, and the second number is now 67% higher than the first one. That’s a bigger hurdle to overcome.
What’s more, progress toward overcoming that hurdle is likely to be slower when we’re dealing with the lower tax rates. Taxes imposed on earnings of the taxable account are likely to be much lighter for someone who will be in the 25% bracket prior to retirement and the 15% bracket afterward, than for someone who is now facing 35% and anticipates a 25% rate in retirement. This means the annual benefit of having money in a Roth account rather than a taxable account is smaller when you’re in a lower tax bracket.
The upshot of all this is that people who expect to be in the 25% bracket or higher during their retirement years should strongly consider a Roth conversion even if the rate of tax on the conversion is as many as ten percentage points higher, provided they can pay the conversion tax with money that would otherwise remain in a taxable investment account and their investment time horizon is a long one. On the other hand, it will rarely make sense to pay 25% or more on a Roth conversion if ATRW is 15%.
As a point of reference, for 2010 the 25% tax bracket begins when taxable income exceeds $34,000 for singles and $68,000 for couples filing jointly. Taxable income is the number you have after claiming deductions and exemptions, so typically you can have around $40,000 of income as a single or $80,000 as a couple before hitting the 25% bracket. If your income in retirement (including IRA withdrawals) will be below those levels on an inflation-adjusted basis, it’s likely that your tax rate will stay below 25%, and that makes it hard to justify paying 25% or more on a Roth conversion.