Many articles on the subject of Roth v. Traditional IRA boil it down to nothing more than an issue of current v. future tax bracket.
The myth goes that if your tax bracket at retirement is expected to be lower than it is now, don’t convert to a Roth, while if your tax bracket is expected to be higher at retirement, do convert to a Roth.
And, if your tax bracket ultimately stays the same, the conversion decision is moot since you’ll end up paying the same in tax either way.
The uncertainty of your future tax situation not withstanding, the “wash” only occurs if you pay the tax due from the IRA you are converting,
in which case, the whole decision is reduced to a bet on future tax rates and on your future tax situation, both of which are highly unpredictable
(not to mention, you will pay a penalty in addition to the tax if your conversion and IRA withdrawal occur before age 59 1/2).
If, however, you pay the tax due on conversion from after-tax money, you are essentially converting the future growth on the amount of tax paid from “taxable every year” to “never taxable again” (assuming you meet the holding requirements of the Roth IRA).
Or to put it another way, the amount of tax paid at conversion is a “bonus allowable Roth contribution.”
Example:
$100,000 traditional IRA, $25,000 after-tax account, 25% tax bracket now and forever, 7.2% annual investment growth.
If you convert, your $100,000 IRA becomes a Roth and your $25,000 after-tax account goes away. After 30 years, you have a Roth IRA worth $800,000 (in after-tax terms).
If you don’t convert, your $100,000 IRA is worth $600,000 (after-tax), while your taxable account is worth $200,000 assuming a 0% tax rate over 30 years.
It’s only a “wash” if you manage to avoid taxes altogether on the original $25,000 after-tax account. In this example, at a 25% tax rate, the initial $25,000 grows to only $121,104.
Takeaways:
1) If you can’t pay the conversion tax from a taxable account (ie, funds you’ve already paid tax on, not from the converted IRA itself), don’t convert.
2) Even if you can pay the tax from after-tax $, it still may not be in your best financial interest to do so. There are other factors involved which may outweigh the benefit illustrated above (future blog post).
This post and all others on the blog are for informational purposes only and should not be considered individual investment or financial planning advice.
Consult your financial planner or tax advisor before making the Roth IRA conversion decision.
Posted via email from Frisco Financial Planning LLC
