Knowing When to Convert an IRA

Too many people are told that because they are seasoned IRA owners, they’re too old to convert a traditional IRA to a Roth IRA. Converting a tradition-al IRA to a Roth IRA can be a good idea at any age, if the circumstances are right. Unfortunately, I still hear from too many people who were told that they’re too old to think about a conversion.

Rule #1 about IRA conversions is to ignore rules of thumb. Each situation is unique.

At Retirement Watch we were among the first to realize that a lot of factors come into play when considering an IRA conversion. Instead of using simple rules of thumb or an intuitive approach, we advised people to use and developed an analysis that incorporated all the factors. A full analysis shows the interplay of the variables and how it affects the results. We developed a spreadsheet that used all the variables and allowed each to be changed. Financial services firms and web sites also developed their versions of conversion calculators so that IRA owners can conduct a real analysis of the situation and make better decisions. Some of the calculators are more robust than others.

To use the calculators or make the decision without one (you can do the analysis with paper, pencil, and a calculator), you should know the key variables and how changes or errors in the assumptions about them could change the result.

When considering a conversion, you want the option that is most likely to give you or your heirs the higher after-tax value over time. It’s important to look at the long term, not the next few years.

The basics of Roth IRAs are well known. The tax benefits are back-loaded, instead of being front-loaded the way they are for traditional IRAs. You receive no deductions for contributions to a Roth IRA. All income and gains compound tax-free in the IRA, and distributions from a Roth IRA are tax free after a five-year waiting period. There are no required minimum distributions for the original IRA owner, but non-spouse beneficiaries must take RMDs over their life expectancies.

The cost of converting a traditional IRA to a Roth IRA is that the amount converted is treated as though it were distributed. All accumulated income and gains are included in gross income, as are any contributions that were deducted. Nondeductible (or after-tax) contributions won’t be included in gross income.

Because of this tax cost of converting, you have to consider a number of variables to decide whether or not a conversion makes sense for you. Let’s take a look at the variables and how they can change the results.

? Length of the post-conversion period. You need time for compounded tax returns in the Roth IRA to make up for paying taxes early. My research over the years has shown a converted IRA needs at least seven years of compounding at an 8% annual return to make up for the taxes. It takes longer at a lower rate of return.

This is the source of the notion that someone can be too old to convert an IRA. But seven to 10 years isn’t a long time for many people, especially when the IRA is not your main source of spending and will be drawn down over a long time.

Some people have sufficient income and assets outside their IRAs to maintain their standards of living. For them, the IRA is an emergency savings vehicle and something to be left to heirs. Converting traditional IRAs in those circumstances to Roth IRAs essentially allows them to prepay their children’s income taxes. The IRA avoids required minimum distributions, so it can be inherited by the heirs untouched.

In addition once inherited, distributions to the beneficiaries will be tax free and can be spread over their life expectancies. Combining all those factors often leaves the beneficiaries with much more after-tax wealth. The conversion is an estate planning tool, and can be very effective.

? The source of the conversion taxes. For maximum benefit, the taxes should be paid from non-IRA funds. If you use IRA funds to pay the taxes, you have to money from the IRA, and if you are under age 59½ will owe the 10% early distribution penalty on that amount in addition to income taxes. (Converted amounts are not subject to the 10% penalty.) It takes longer for a conversion to pay off when the conversion taxes are paid from the IRA. You want to roll over the entire traditional IRA to the Roth IRA.

? Changes in tax rates. A major factor is any difference between the tax rate in the year of conversion and the rates in the distribution years. Remember that distributions from a traditional IRA are taxed as ordinary income while Roth IRA distributions are tax free. If you are confident your ordinary income tax rate will be lower when you take most distributions, it is likely a conversion won’t be profitable (unless you’re a long way from taking distributions). But conversions often make sense when your tax rate will be the same or higher in the future.

Carefully consider future tax rates. Required minimum distributions from traditional IRAs kick in after age 70½. Many people find that in their late 70s or so the RMDs are much higher than they need for spending, push them into higher tax brackets, and increase stealth taxes (discussed just below). Avoiding RMDs or having tax-free IRA distributions would save them a lot of money. 

? Effect on current taxes and tax-related factors. If you convert a sizeable amount, it could push you into a higher tax bracket, decreasing or eliminating the benefits of the conversion. Also, including the converted amount in gross income could trigger the stealth taxes: the Medicare premium surtax, loss of personal exemptions and itemized deductions, inclusion of Social Security benefits in gross income, phasing out of some tax breaks, and more. Each of these is a potential additional cost of converting the IRA and lengthens the payoff period.

One way to avoid or reduce this cost is to convert an IRA in stages instead of all in one year. Convert just enough of an IRA each year to keep you in the same tax bracket and avoid triggering the stealth taxes.

Don’t forget state income taxes on both ends of the conversion. If your state has an income tax you likely will owe taxes on the conversion. Also, some states don’t recognize Roth IRA distributions as tax-free, so you might owe state taxes on the future distributions.

? Investment rate of return. The higher the rate of return on the investments, the shorter the payoff period. But if you plan to invest conservatively for a low rate of return, the payoff period will be longer. If you expect to earn a high rate of return, a conversion means that paying taxes today ensures those future returns are tax free. Realistically assess your likely rate of return.

? Tax diversification. You can’t know what the tax law will be like in 10 or 20 years. Your assets shouldn’t be structured according to what is best today. Tax diversification to protect you from major tax law changes. Have some money in taxable accounts, tax-deferred accounts, and tax-free accounts.

Tax diversification also gives you more flexibility. As I’ve shown in past visits, owning different types of accounts lets you structure sources of income each year so you stay in the 20% tax bracket or lower instead of having traditional IRA RMDs push you into a higher bracket.

? Changing your mind. A conversion is not a one-time decision. If circumstances change or you decide the conversion was a mistake, you can reverse the conversion, a transaction known as a recharacterization. You have until Oct. 15 of the year following the conversion to recharacterize, if you filed your tax return on time. You might want to recharacterize if the value of the IRA declined, for example. Monitor the IRA and the other variables after the conversion to decide if you should recharacterize.

To help you make the conversion decision, I constructed a Microsoft Excel spreadsheet that incorporates all the variables and lets you change them at will. The problems with many web calculators are failure to consider all the variables and requiring defaults for some variables. You can find more about the calculator on the home page of the members’ section of our web site at www.RetirementWatch.com.

When you don’t want to do the full analysis, consider the simpler formula offered by William Baldwin of Forbes. Baldwin’s formula is to multiply your portfolio’s estimated rate of return by the tax rate on your portfolio, and then multiply that result by the number of years before you will withdraw money from your converted IRA. You shouldn’t convert if you expect your ordinary income tax rate to decline by more than the result of that formula from working years to retirement. Otherwise, conversion probably is a good idea. He calls the formula RTN.

Suppose you expect to earn 6% a year and pay a 20% tax rate for 15 years. Multiplied together, your RTN is about 18%. If you think your ordinary tax rate will decline by more than 18% in retirement from your pre-retirement rate, then you might not want to convert. That’s not 18 percentage points, but 18%, or less than a fifth.

It’s a simplification, but if you don’t want to do the full analysis, it’s not bad.

The debate over converting an IRA really is a debate over whether it is better to pay taxes now than later. Most taxpayers were taught to defer taxes whenever possible. That’s not always the best advice today, especially with the expansion of stealth taxes that primarily harm retired taxpayers and the potential for higher tax rates in the future. Instead of looking at only a few factors or using a rule of thumb, examine the variables closely and make the best decision for you.

RW February 2015.