Looking for advice on whether to rollover a large IRA to Roth when the money has at least 25 years to grow

[Guest JeffH]

Hi,

I have a Traditional IRA with a few hundred thousand dollars in it. I'm trying to decide whether to roll it to a Roth IRA, and would appreciate any advice.

It would seem that if I were to roll it, I would only want to roll part of it to keep myself from going into too high a tax bracket. I won't have any significant income this year, so the amount of the rollover would pretty much dictate my bracket. I'm thinking I would probably want to only roll $100,000 - $120,000 to keep myself in the 28% bracket. In addition, I live in CA, so I'm stuck with 9.3% state taxes (I assume I have to pay state taxes on the rollover, but I'm not positive about that).

I found this on fairmark.com: "If your time frame is very long — say, 10 years or more before you begin taking withdrawals — tax rates are not much of a factor, partly because the long-term benefit of the Roth IRA will outweigh the added tax cost and partly because no one can predict what tax rates will be like that far in advance."

I'm not sure I understand that advice. I'm 35 years old now, so the money will sit in the IRA for at least another 25 years. But, as I try running the numbers and using different potential future tax rates, it seems that the future tax rate does make a big difference, and that I might be better off leaving the money in the Traditional IRA. I'm very confused by the assertion that "If your time frame is very long ... tax rates are not much of a factor".

To roll $100,000 this year, I think I'll have to pay about $36,000 in taxes (between Federal and CA). That $36,000 could grow a lot in 25 years, and even though I'll have to pay taxes on it and the Traditional IRA in the future, it looks like I could still end up with more money if I'm in a low enough bracket in the future (relative to the 28% bracket I'd be putting myself in by doing the rollover).

Many thanks in advance for any help, advice, or thoughts.

Jeff

[Bird]

Interesting scenario. I assume from your comments that you DO have $36,000 in other money to pay the taxes? If not then the whole thing blows up; that may appear obvious but I figured I say it anyway.

My gut reaction is that I wouldn't do it. I think the fairmark comment is off-base; tax rates are very important in the analysis. I wouldn't be so anxious to pay 39% now.

FWIW.

[mbozek]

The only advantage to converting a roth is if no distributions are taken from the Roth IRA and the assets continue to compound tax free until later of the death of the owner and spouse whereas IRA distributions must commence at 70 1/2 and will be taxed at marginal tax rates. Otherwise the loss of investment opportunity on 36K in after tax money which gets the benefit of the 15% tax rate for dividends and cap gains outweighs the benefits of converting to a Roth. For example, the future value of 36K with an after tax rate of return of 6% for 50 years will be 663k. You need to hire a financial planner to do an analysis.

[joel]

And make sure the planner is not a salesperson. You may also want to post your question on Forum@yyyz.net.

Let us know how you make out.

[Guest JeffH]

Thanks for the responses. I just posted on Forum@yyyz.net and the fairmark.com forum (should've thought to do that yesterday :-) ).

1) I do have cash on hand to pay any taxes I would incur on the rollover.

2) Maybe I'll try talking with a financial planner. Any recommendations on where to find a good one? I'm in San Francisco.

I was hoping I could get as good advice here or elsewhere on the Net. I set up a pretty simple spreadsheet to run what I think are the relevant calculations (kind of similar to the calculators out on the Net). My variables are: Principal in Traditional IRA, Current Federal Tax Rate, Current State Tax Rate, Predicted Interest Rate, Years Invested, Retirement Federal Tax Rate, and Retirement State Tax Rate. Using those I think I can calculate the future expected values in the different scenarios.

3) Another idea is that I could just roll $50,000 or so, and be in the 25% bracket. The problem then is just that I leave a large percentage of the money in the Traditional IRA. Maybe I can continue to do partial rollovers of that amount in later years. But, I might get married and run into the $100,000 restriction disallowing rollovers, or I might get a job and push myself back into a higher tax bracket.

Again, thanks for the responses, and any other advice that might be forthcoming.

Jeff

[Guest JeffH]

I just posted this to the yyyz.net Forum, and figured I would post it here, too.

Here's the math I've done.

I'm assuming the following values:

Current Principal in IRA = $100,000

Fed Tax Rate = 28%

CA Tax Rate = 9%

Interest Rate at which money will grow = 8%

Years money will grow = 25

Fed Tax Rate at Retirement = 15%

State Rax Rate at Retirement = 7%

So, if I convert the $100,000, then I pay $37,000 in tax, and the Principal grows to $684,848.

If I don't convert, then at retirement I pay $150,666 in taxes on the $648,848, leaving me with $534,181. But, the $37,000 that I didn't pay in taxes has grown to $253,394. I'll pay $55,746 in taxes on it, leaving me with $197,647. Adding that to the $534,181 gives me $731,828, which is more than the $684,848 I'd get by converting.

This would seem to indicate that I shouldn't convert. I'd appreciate any thoughts you have on what I might be not be doing correctly with my calculations and assumptions.

Jeff

[John G]

Disclosure: I did two substantial conversions in 1998 when I could keep our join income low, pay the taxes over 4 years and I had some very good investments that rapidly grew the Roths. So far, the conversions have worked for me but I am an outlier.

The comment from fairmark is a generalization - and I would disagree with it. Tax rates can be significant. For example, if you were to retire to a lower tax rate state or one of the states with no income tax, you would be probably better off not converting as a California resident. If rates are equal on both ends, conversions vs no conversion should be very close to a wash.

I would also suggest that predicting future tax rates is very difficult. Only 6 years have passed since the Roth conversions started - and how many of us expected 15% long term capital gains taxes and 15% tax on dividends? Probably none, not even the average Republican.

Over a very long period of time, folks often fail to comprehend the potential magnitude of their nest egg in future years. Contrary to all the doom a gloom in the media, there is a very significant probability that a college educated person will accumulate more than a million in retirement assets, and quite a few will built a multimillion nest egg. Because many folks lose their deductions and have paid off the mortgage by the time they retire, they can have tax rates similiar to their prime work years.

You absolutely need to spend some money and get advice from a financial planner, maybe even two planners. Be very cautious about developing a personalized spreadsheet - I have seen too many spreadsheets with agregious errors in logic, typos, etc.

There are many scenarios where the conversion may look good. Also, a hybrid approach is often attractive because it gives you flexibility in placing your investments (IRA vs Roth), planning your withdrawals (Roths have not set schedule, IRAs do) and estate planning benefits. You could aim for small annual conversions to avoid tax bracket creep, but the regs could change, your income could eliminate your eligibility, or your could marry.

It is fairly likely that ROTH and IRA rules will change a few times. They already have. Changes in the regs can cut either way and nearly impossible to predict.

I hope you don't mind uncertainty.