The Roth Conversion Benefit No One Understands

Missing the biggest point

Repeal of the income restriction on Roth conversions is one of the hottest topics in personal finance, spawning hundreds of newspaper, magazine and website articles over the past several months. I've read many of them, and I have yet to find a single one that mentions the number one reason for doing a conversion: it can expand the tax benefit you get from your retirement savings by more than 50%.

I imagine there are two reasons no one mentions this point. The first is that a benefit this great is available only to people who are quite wealthy — specifically, people who will remain in a high tax bracket even after retirement. Perhaps more importantly, this tax benefit is a little difficult to explain. There are a few steps in the logic, but taking the time to understand it will be rewarding even if you expect to be in a lower tax bracket when you're withdrawing money from your IRA, because the analysis will help you know where to draw the line on a Roth conversion.

Throughout the analysis I'm assuming that you will avoid nonqualified distributions from your Roth; in other words, you'll pay no tax or penalties on any of your withdrawals.

---

Update: Response to this article from readers indicated I should have preceded this discussion with an explanation of what I mean in referring to the tax benefit produced by a retirement account. Please visit this page before continuing.

---

Three situations

We'll begin by looking at three simple situations:

• A: You have $100,000 in a regular, taxable investment account and no IRA savings.
  
• B2: You have $35,000 in a taxable investment account and $65,000 in a Roth IRA.
  
• C: You have $100,000 in a Roth IRA.
  

In all three cases you have $100,000. Situation A is provided as a point of reference, where you are not getting any special tax benefits because none of your money is in a retirement account. Situation B2 differs in that you have $65,000 in a Roth IRA. That's a big advantage over situation A, because the earnings on this portion of your money will be tax-free. Your money can grow faster in a tax-free account than in a taxable account, and over a long period of time the difference can be substantial.

It would be nice if you could move from B2 to C, because then the investment earnings on all your money would be tax-free. The amount of money growing tax-free would increase by 54% ($100,000 is 54% more than $65,000). Unfortunately, the tax law doesn't allow you to simply add $35,000 to your Roth IRA.

What about B1?

No doubt you've noticed that I labeled the second alternative B2. I did that to leave room for B1. In this situation you have $100,000 in a traditional IRA and, in addition, you have $35,000 in a taxable account. We're going to assume that a tax projection indicates that your tax rate is going to be 35% when you take your money out of the traditional IRA. Remember, we said earlier that the greatest tax benefit is for people who will be in a high tax bracket when taking money from their retirement accounts.

Now, if you compare B1 with B2, you'll see that in both cases you have $35,000 in a taxable account. That part of your situation is unchanged, so we can ignore the taxable account for the time being. The difference is that in B1 you have $100,000 in a traditional IRA, and in B2 you have $65,000 in a Roth IRA. Which is better, assuming you're going to pay 35% tax on money you take from the traditional IRA?

• They start out the same, because both the traditional IRA and the Roth represent $65,000 in spendable dollars.
• If you leave the money in the account long enough to double, both situations still represent the same amount of spendable dollars. The TIRA doubles to $200,000 but the 35% tax leaves you with $130,000. Meanwhile the Roth doubles to $130,000, which is tax-free.

For someone who is going to pay 35% tax on IRA withdrawals, a $65,000 Roth has exactly the same value as a $100,000 traditional IRA. Situation B1 produces exactly the same tax benefit as situation B2.

This may seem strange because traditional IRAs and Roth IRAs seem like completely different beasts. In reality, they are two different ways of delivering the same tax benefit, at least under this set of assumptions. For years I've been calling this the parity principle. In essence it says that investing pre-tax dollars in a tax-deferred account produces the same result as investing after-tax dollars in a tax-free account.

Conversion: from B1 to C

We saw earlier that moving from B2 ($65,000 in a Roth and $35,000 in a taxable account) to C ($100,000 in a Roth) would increase the tax benefit you get from your retirement account by 54%. You aren't allowed to do that. You can, however, move from B1 ($100,000 in a TIRA plus $35,000 in a taxable account) to C ($100,000 in a Roth). All it takes is a plain vanilla Roth conversion, where you use the money from the taxable account to pay the tax.

Get complete guidance on Roth
IRAs in our book, Go Roth!

It may be hard to believe, but the logic is inescapable. B1 and B2 produce exactly the same results. C produces 54% more tax benefit than B2. Therefore C produces 54% more tax benefit than B1. A simple conversion — one in which the entire conversion amount is taxed at the highest current tax rate of 35% — gives you a 54% increase in the future tax benefits you get from your retirement savings.

This is a stunning result. Consider all the effort you've expended over years, perhaps decades, in trying to maximize the tax benefits of your retirement savings. Now, in a single cost-free transaction, you push a button and get this huge increase in the future tax benefit.

Check my work

The concept here is unfamiliar, and I often run into people who have a hard time accepting it. They figure there must be a sleight of hand somewhere. Perhaps I'm not fully accounting for the fact that you have to pay $35,000 in income tax when you do the conversion. In reality, I have fully accounted for it, but just to be sure, let's do a side-by-side comparison between what happens if you don't convert (B1) and what happens if you do (C).

No Conversion	Conversion
Initially you have a $100,000 TIRA (representing $65,000 spendable) and $35,000 in a taxable account, for a total of $100,000 spendable.	Initially you have a $100,000 Roth (all spendable). Conversion did not change your spendable amount.
If investments double, TIRA goes to $200,000 (representing $130,000 spendable) and taxable account goes from $35,000 to $70,000 reduced by taxes paid on the investment earnings. Total spendable is $200,000 reduced by taxes paid on earnings of taxable account.	If investments double, Roth goes to $200,000, and the entire amount is spendable.

 

The result checks out. The only difference in the results is that conversion eliminates tax on the earnings produced by the money that would otherwise be in the taxable account. This is exactly what the earlier logic would predict.

There are ways a Roth conversion can produce even richer rewards. For example, it eliminates the need for the original owner (or a spouse beneficiary) to take required minimum distributions, creating the possibility of preserving the account for a longer period of time. Also, when the account being converted includes after-tax dollars, a conversion provides a bigger bang for the buck. Strangely, many people, including professional advisors, focus on these additional benefits and completely ignore the most important one, which is the opportunity to shelter more investment earnings from tax.

---