In the November 2009 issue of the AAII Journal, Christine Fahlund of T. Rowe Price discussed the issues facing investors considering whether to convert their traditional IRA (Individual Retirement Account) into a Roth IRA in light of eligibility changes that will go into effect in 2010.
Roth IRA conversion carries with it several advantages, including:
These benefits come at a cost—current taxes must be paid on the amount of your traditional IRA (earnings plus deductible contributions) converted to a Roth IRA.
In general, for those who expect their tax rate to increase, a Roth conversion could pay off in the long run. However, there are a number of considerations that can influence your decision to convert to a Roth IRA or not. These include:
Also, Dr. Fahlund recommends that any taxes incurred because of the conversion should be paid from a separate taxable account and not the IRA itself.
Dr. Fahlund presented three different investor scenarios, with differing assumptions regarding years until retirement and current IRA holdings. However, there are additional variables that come into play when considering whether or not it is worthwhile to convert a traditional IRA to a Roth IRA, such as tax brackets and rates of return.
If you are looking for a tool to help you decide whether to convert to a Roth IRA, we have created a Roth IRA Conversion Spreadsheet that you can download from the Computerized Investing Web site at www.aaii.com/ci/jan10/rothconvert.xls.
We modeled the spreadsheet after the tables in the article and the T. Rowe Price Roth IRA Conversion Worksheet, which is available for free from the T. Rowe Price Web site: http://individual.troweprice.com/staticFiles/Retail/Shared/PDFs/RothIRAConverstionWorksheet0514006wbi.pdf.
For a more detailed explanation of the Roth IRA conversion process, refer to Christine Fahlund’s November 2009 AAII Journal article, “Retirement Plans: Evaluating the New Roth IRA Conversion Opportunity,” which is available at AAII.com.
The spreadsheet is divided into two main areas—User Inputs and Conversion Analysis. Figure 1 shows the User Inputs section. [Note that some cells in the figure are hidden, as they do not require user entry. However, the spreadsheet you can download has no hidden cells.] The User Inputs section is where you enter in the data that drives the underlying calculations performed by the spreadsheet. The cells highlighted in yellow are those requiring user data entry, while the cells in blue show data calculations based on your inputs.
The User Inputs section is divided into three parts—Current IRA Holdings, Accumulation Period, and Distribution Period.
The inputs you provide in this section relate to the accumulation period—the period between when you start your IRA and when you begin to withdraw funds from your account.
The inputs you provide in this section relate to the distribution period—the period during which you are withdrawing funds from your IRA account.
Based on the assumptions you make when entering in the user inputs, the spreadsheet determines whether it is better to convert to a Roth IRA or to stick with the traditional Roth IRA. Figure 2 illustrates the spreadsheet output for determining the aftertax income from converting and not converting. However, this spreadsheet is intended to offer only general guidance. Be sure to consult your financial planner or accountant before converting to a Roth IRA.
The spreadsheet looks at the aftertax income generated by the traditional IRA and Roth IRA over the distribution period to determine which choice is optimal. In order to compare the withdrawals of a traditional IRA to a Roth IRA, we assume that the “conversion tax” paid when converting a traditional IRA to a Roth IRA is invested in a taxable investment account. This takes the place of the taxes that would have been paid at the time of the conversion, and the taxes are eventually subtracted from the traditional IRA over the distribution period. Adding the aftertax payments (withdrawals) of the invested conversion tax savings to the aftertax withdrawals of the traditional IRA makes for a better comparison to the withdrawals of the Roth IRA, which are not taxable. In a departure from Dr. Fahlund’s article in the AAII Journal, we assume that all of your IRA holdings are paid out over the distribution period. Furthermore, the distribution period payments are fixed, whereas the calculations in the Journal article assumed an annual increase in the payment.
Based on the assumptions used in our example, the Roth IRA would generate aftertax retirement income of $1.54 million, while the combined income from the traditional IRA and the invested conversion tax would be $1.43 million, for an aftertax advantage of over 7% with the Roth IRA conversion option.