Roth IRA Conversion

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:

• The ability to withdraw converted assets from a Roth IRA tax-free at any time;
• Any future earnings in the Roth IRA account are also tax-free (with some limitations); and
• Account holders are not required to take minimum distributions during retirement.

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:

• How long is it before you expect to start taking distributions?
• What do you expect your tax bracket to be in retirement?

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.

A Customized Scenario

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

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.

Current IRA Holdings

• The Total Value of Traditional IRAs is the amount of money you currently have in traditional IRAs that you wish to convert to a Roth IRA. In this example, we currently have $100,000 in a traditional IRA account. Note that we assume that no further contributions are made to the IRA account during the accumulation period.
• Basis Amount is the amount of any nondeductible contributions you have made to your traditional IRA, minus any nontaxable withdrawals. For more information on this, refer to IRS Form 8606 (www.irs.gov/pub/irs-pdf/i8606.pdf). In our example, we have not made any nondeductible contributions, so the basis amount is zero.

Accumulation 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 Years of Accumulation are the number of years you expect to have your IRA before you begin withdrawals. In order to receive tax-free withdrawals, you must keep a Roth IRA for at least five years. Therefore, be sure to enter a number greater than or equal to five. In general, the farther away you are from making withdrawals from your IRA, the more advantageous it is to convert to a Roth IRA, as there is more time for the account to grow tax-free. For this example, we do not expect to begin making withdrawals for another 30 years.
• Rate of Return During Accumulation is the rate of return you expect to earn on your IRA assets during the accumulation period. The higher the rate, the more IRA assets you will have when you begin making withdrawals. However, it is important to be realistic in this assumption. Between 1945 and 2008, the annualized return in the S&P 500, adjusted for inflation, has been roughly 6.5%. We assume a rate of return of 8% during the accumulation period in this example.
• One of the deciding factors of whether to convert to a Roth IRA is your current tax situation relative to what you expect it to be when you begin withdrawing from your IRA account. The Accumulation Period Tax Rate is where you enter in your current marginal federal income tax rate. This is the tax rate on your last dollar of income and applies to your current federal income tax bracket. If you wish, you can also enter a combined state and/or local marginal tax rate, or you can enter zero for this amount. The amounts you enter for the federal and state/local tax rates are used within the spreadsheet to arrive at the Accumulation Period Effective Tax Rate, Accumulation Period Aftertax Rate, and Accumulation Period Aftertax Rate of Return. In Figure 1, these three values appear in blue cells, so you do not have to enter any values. The spreadsheet automatically calculates them based on your entries for the marginal tax rates. In this example, we assume a 33% federal marginal tax rate and a 5% state/local tax rate, giving us an effective tax rate of 36.35%.

Distribution Period

The inputs you provide in this section relate to the distribution period—the period during which you are withdrawing funds from your IRA account.

• Years of Distribution refers to the number of years you expect to withdraw from your IRA. This is influenced by your life expectancy and the age at which you expect to begin taking distributions. For our example, we expect to make withdrawals for 20 years.
• Rate of Return During Distribution is the annual rate of return you expect to earn on your IRA assets during the distribution period. If you want, you can use the same rate you used for the accumulation period. However, for our example, we expect to earn a lower return of 5% during the distribution period.
• Distribution Period Tax Rate refers to the marginal tax rate (or tax bracket) you expect when you begin making withdrawals from your IRA. If your tax rate drops significantly after retirement, there are potentially less benefits to converting to a Roth IRA, since you would be paying taxes on any earnings at a higher rate now. However, if you expect your tax rate to increase in retirement, conversion is attractive since taxes paid as a result of conversion would be paid at a lower rate, while withdrawals from a traditional IRA in retirement would be taxed at a potentially higher rate. Again, you also have the option of entering an expected state/local tax rate. These entries are used in the calculations for a distribution period effective tax rate, distribution period aftertax rate, and distribution period aftertax rate of return (not shown). For our example, we assume our federal tax rate will drop to 25%, while the state/local rate will remain at 5%, giving us an effective tax rate of 28.75% for the distribution period.

To Covert or Not to Convert?

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.