Traditional IRA Conversion?

[Guest machIcj]

Since 1987, my traditional IRA has grown to over $100k. I don't know if I should convert it to a Roth IRA. I now contribute to a Roth IRA. My current tax bracket is 28%. My spouse and I make less than $100,000 per yr. I'm 52 yrs. old and would like to retire at age 62. I also have savings money to pay the ordinary income tax. Is a conversion right for me? Anything else I need to know? Thanks for any help.

[John G]

Annual income under 100k is needed to qualify for a conversion if you are married filling jointly. When you convert all/part of your IRA you will immediately increase your income and you could easily jump up a bracket or even two. That is not a great idea if in retirement you would be drawing down on your IRA at 28% or lower. On the other hand, if you have reason to believe that your income and assets will grow substantially and in retirement you will be at 28% or higher then a conversion might make sense. The conversion might be attractive if you plan not to use the Roth during your lifetime but to pass it on as part of your estate, or if you just want a better control of dispersements since there are no required start dates or required schedules with a Roth.

If you expect to stay below the 100k limit for a few years, you might want to consider converting just a partial amount each year, say perhaps 10k. The case to convert is stronger if your current state has no income tax state but you may later live in a state with income taxes in the future or in retirement. Often a hybrid solution: part IRA , part Roth gets you lots of flexibility and benefits without the immediate tax impact of a full conversion.

To think through a conversion decision, you need a spreadsheet or conversion calculator. Assumptions you need to make include tax rate now, tax rate in drawdown, number of years to you start drawdown, likely annual rate of return on investments, etc. Since these predictions look into the future 10 or 20+ years, the accuracy of assumptions is suspect. A number of mutual fund and brokerage web sites used to have Roth conversion calculators. Sadly, many of these were too simplistic or had math/structural errors. Perhaps another reader can comment on the state-of-the-art or see the articles at www.rothira.com . You may want to see if your accountant has access to a good spreadsheet.

There is no simple answer to your question. Often convert and stay IRA produce very similiar results. If both you and your spouse are over 50 years old, you can put $3,500 each into a Roth while you ponder the conversion option.

[mbozek]

You can look at your options as an economic choice. Assuming you transfer 20K a year and your tax bracket is 28% fed/5% state, then your out of pocket cost is going to be $6600 a year which is the amount that you can put into a roth IRA for u and your working spouse and invest without paying any future taxes. I guess I dont understand why u want to pay taxes on a conversion from a pre tax IRA to a roth IRA when you can use the tax money to establish a roth IRA for you and your spouse and let your pre tax money compound for another 10 or 20 years in which would double every 10 years at a 7% return so that you would have almost 400k at age 70.5 plus you non taxable roth contributions.

[John G]

Mbozek, I like your response a lot. However, you ran things out to age 70 and machIcj seemed to want to retire at age 62... about 10 years from now. I enjoy crunching the numbers, so I ran out some scenarios on my HP 12c:

IRA: 100k initial in the IRA grows by age 62 to $197K or $ 259K using 7% or 10%, and if left untouched to age 70 the assets will be about $338K and $556K. The 7% would represent a mostly bond/utility portfolio and the 10% would represent a general mix of stocks with just some bonds. I would pick 10% for the very long term rate, perhaps a bit lower for the shorter scenarios.

ROTH: The annual Roth approach using the $6,600 (Mbozek's taxes paid, which is less than the likely 7,000 current max) would create $91K or $105K using 7%/10% by age 62 or $224K or $300K they worked/contributed to age 70. {wouldn't be my plan... but worth illustrating}

Upon retirement: I would imagine there would be the following components of income: (1) SSN, (2) pension, (3) possible IRA withdrawal, (4) other interest and dividends, and (5) possible Roth withdrawals. In the early years, this person might want to draw down on savings, or if they move to a smaller home they might burn off some of the home equity. Depending upon how long you let the IRA grow and the annual return you expect, your income in retirement could vary substantially. Note, that with the Mozbek strategy, the Roth assets are about 2/3 the IRA assets at age 70, or 1/3 at age 62. The hybrid IRA/Roth strategy helps mitigate total taxable income in retirement and gives you some timing/estate flexibility.

There are lots of unknown circumstances like other assets, pension, wifes age, investment experience and risk tolerance, home equity, and health status. I don't presume to know the answer to the original questions, but I hope this data helps illustrate some of the scenarios. In my experience, lots of folks underestimate their future economic situation because it is hard to project out decades into the future. I hope this helps machIcj.

[mbozek]

JohnG: thanks for the number crunch which confirmed my off the top of the head response that Roth IRA conversions for most taxpayers are very expensive financially because of the opportunity cost due to the loss of the fed and state tax payments for future investment. The Roth IRA conversion makes the most sense for workers who are in the 15% tax bracket and/or who have depreciated IRA assets for conversion which minimizes the amount of taxes due. It does not make sense for most taxpayers because of the fact that the taxes have to be paid from non IRA assets which reduces the amount of investible assets for retirement.

[John G]

Mbozek, I never said that conversions are "very expensive" due to tax payments. My examples did not even attempt to show the net values of conversion and non-conversion. Actually, if the tax bracket is the same now and in the future, then a Roth conversion is roughly a wash. Pay now, pay later. The money you would use to pay taxes now vs that same money allowed to grow to pay the larger tax bill in the future. The most simplistic view is that both scenarios are the same. However, each individual will have specific circumstances that may make conversion a good or bad idea.

Here are the some of factors that tip the scales towards a conversion: (1) your current tax bracket is likely to climb in future years due to your success, (2) you are younger and have a very long compounding period of 30+ years, (3) you currently live in a state that does not have an income tax, (4) you suspect that you may not qualify for a conversion in the future and want to do it now, (5) you think Congress may change conversion rules and end this option, (6) you seek to control the timing of your dispersements, (7) your assets are substantial and you want to use the Roth as an inheritance planning tool, and (8) you are a very good investor getting a high annual return. This last point needs some clarification. I know of two people that have averaged annual returns well in excess of 15% per year in their IRA/Roths over more than a decade. They expect to have multiple million dollars of IRA assets in 30 years and can not conceive that their tax rate will ever be lower. They both did substantial conversions in 1998 and have since more than doubled their Roth assets.

I find no logic to your comment about "depreciated IRA assets". I assume you mean depressed values. This sounds like you think investments are somehow elastic and that eventually every depressed stock rebounds. Not true. Enron? Montgomery Wards? I think you should take the current snapshot of your IRA assets as a given and make a conversion decision independent of you expectations about a specific stock or the overall market. Converting a depressed stock is playing a hunch. I have never met anyone who can say "this is the bottom" or "this is the top" with any accuracy. At the recent market peak, where were all the folks who "knew" that a top had been reached. At 9800 DOW are we at a short term bottom? This is conjecture not analysis.

Your concluding sentence was: " It does not make sense for most taxpayers because of the fact that the taxes have to be paid from non IRA assets which reduces the amount of investible assets for retirement." This statement suggests that conversion is generally a bad idea. It fails to recognize that the front end costs while painful are largely offset by bigger tax costs on the back end. I don't believe that conversions are bad for "most" taxpayers. There are plenty of folks who can be better off by converting. For many others, to convert is about even with not converting but the parties may value being rid of minimum annual dispersements. My conclusion would be: a Roth conversion is neither bad idea nor a panacia and each tax payer must evaluate their specific facts.

[JAMES PATRICK]

While you guys have done an excellent job of spelling out a lot of the pros and cons I can't let my pet peeve escape without being mentioned and that is Social Security benefits.

Individuals MUST consider how they will be taxed at retirement and how the inclusion of MRD's will impact the tax rate and amount of benefits to be taxed.

[John G]

Agreed. I see a lot of folks who are surprised in retirement about their tax rate. They have a couple of pension income components. Plus SSN. If they downsized the house, their is often a cash component spinning off interest. Perhaps there is some inheritance components giving dividends. If they retire early, they may have gotten a lump sum from an employer. The old mortgage interest rate deduction may be gone along with exemptions from children. Add the required IRA distributions and wham.... a high tax rate. Successful couples just don't drop down to 15% rate and many can't even find 28%.

I totally accept your recommendation that your tax status in retirement is complicated by what components are taxable and how that impacts SSN. Not all of the planning tools account for these issues. Since we are talking about 10, 20 and 30 years in to the future you also have the problem of knowing what rules might be in effect then.

[mbozek]

While tax rates do have an impact on disposable income in retirement, the goal of financial/retirement planning is to provide for an adequate amount of retirement income, not to minimize income taxation. Eg. a retiree could avoid income taxation on non retirement assets by buying muni bonds but that would not provide the same level of income available in taxable investments. Trying to determine the future effect of taxes on ss benefits, investments, retirement benefits, etc, turns financial planning into crystal ball gazing because future tax rates and deductions cannot be predicted. I generally advise clients more than 15 years from retirement to ignore ss benefits in determining the amount of retirement income needs since there is too much uncertainty in determining benefit levels and taxation. The fact that a retiree might be in a higher than expected tax bracket is not necessarily a bad thing since the retiree will be receiving more income. Losing the mge deduction because of a mge payoff is not significant since by the time of retirement most mge payments are 80% or more principal, not interest and living expenses are reduced because there is no monthly mge payment. Most financial advisors recommend that mges on the primary residence be paid off by retirement to reduce cash flow needs. In 2002 the 27% bracket for a married couple is available for taxable income up to $112,850. Less than 10% of all taxpayers have incomes above that level.

[Guest machIcj]

Thanks everybody for all your help! There were several bits of wisdom I never thought of. Our combined income is real close to $100k. Even a $10k conversion would probably put us over the top. We would also have to pay state tax, which I never thought of. Again, I say thanks. machIcj

[John G]

My point was that too often people assume a drop in tax bracket in retirement and in my experience a drop for today's professionals/managers is pretty rare. Why? Because folks in higher tax brackets or with advanced degrees have generally been successful in life and accumulate assets, home equity, pension and SSN income streams. I can't remember the last time I talked with someone who dropped from 28-31 % to a simple 15%. That 10% part of the population with high incomes is a fast growing group. The group just below them often exceeds 80% of pre-retirement income from the combination of sources.

If people are making decisions about retirement based upon a significant drop in tax rate, I would suggest they crunch the numbers because they are likely to be making a wrong assumption.

Here is a test question: "If you are systematically contributing as part of a plan for retirement, at what age will you have accumulated half of your retirement assets?"

If the person is getting a 10% annual return, the answer is that they will have accumulated more than 1/2 of their retirement assets seven years before they retire. In the last 7 years, this nest egg is likely to double. Rule of 72. A 10% annual rate gets assets to double in about 7 years. Ask the average adult and you will get answers like 10-15 years before they retire, because they just don't incorporate annual compounding into their projection of asset growth.

It is my experience that people currently working often underestimate their future financial circumstances.