By FPA member Dr. William Reichenstein, CFA, Douglas Rothermich and Alicia Waltenberger
Last Updated: December 7, 2009
Recent tax law changes create an opportunity to consider converting a traditional retirement account to a Roth Individual Retirement Account (IRA). Beginning in 2010, anyone will be eligible to convert funds from a traditional IRA, 401(k) or 403(b) to a Roth IRA. Prior to 2010, there has historically been a significant income limitation (of no more than $100,000 of modified adjusted gross income for single and married filers) that prevented many people from taking advantage of such a planning opportunity. With this tax law change, beginning in 2010 you can now convert funds to a Roth IRA, but should you?
While the decision to convert to a Roth IRA makes sense for some individuals, it is not a wise move for all. For most people, the major factor affecting the wisdom of this decision is whether they will have a higher marginal income tax rate in the conversion year or later in retirement when the funds would otherwise be withdrawn from the traditional IRA, 401(k) or 403(b). The purpose of this paper is to explain why the comparison between these two marginal tax rates should be a major factor influencing most people's decision to convert funds to a Roth IRA in 2010 or beyond.
A Roth IRA conversion is the act of moving funds from an existing traditional IRA, 403(b) or 401(k) plan to a Roth IRA. The converted funds are taxed in the conversion year. An example will illustrate the importance of the comparison between the marginal income tax rate in the conversion year and the marginal income tax rate in retirement. We will compare two strategies. First, you convert funds to a Roth IRA in 2010, retain them in the Roth IRA until years later in retirement, and then withdraw and spend the funds. Second, you retain funds in a traditional IRA, 401(k), or 403(b) and then withdraw and spend the funds years later in retirement.
Let's assume you are considering converting $10,000 from a traditional IRA to a Roth IRA. Further, let's assume you will have a 20 percent marginal tax rate in 2010 but will have a 30 percent tax rate in retirement. If converted, the $10,000 of pretax funds in the traditional IRA becomes $8,000 after taxes in a Roth IRA. For simplicity, we assume the funds have a 100 percent cumulative return between 2010 and the withdrawal year in retirement, but the decision to convert to a Roth IRA would be the same whether the return was lower or higher. The $8,000 (after taxes) in the Roth IRA grows to $16,000 after taxes at the time of withdrawal in retirement. Since withdrawals from this Roth IRA would be income tax free, you could withdraw these funds and buy $16,000 of goods and services. If not converted, the $10,000 grows tax deferred in the traditional IRA. Using the same return assumptions, at withdrawal in retirement, it is worth $20,000 before taxes or $14,000 after paying income taxes at 30 percent. Thus, you could buy $14,000 of goods and services. This example illustrates that you should consider converting the funds to a Roth IRA account if you anticipate that you will be in a higher tax bracket in retirement.
Next, let's assume you will have a 30 percent marginal tax rate in 2010, but will have a 20 percent tax rate in retirement. If converted, the $10,000 of pretax funds in the traditional IRA becomes $7,000 after income taxes in a Roth IRA. The $7,000 after taxes grows to $14,000. So, you can withdraw these funds from the Roth IRA and buy $14,000 of goods and services. If not converted, the $10,000 grows to $20,000 before taxes in retirement. At withdrawal, the $20,000 before taxes becomes $16,000 after paying income taxes at 20 percent. So, you can buy $16,000 of goods and services. This example illustrates that, from an income tax perspective, you should not convert the funds to a Roth IRA if you anticipate that you will be in a lower tax bracket in retirement.
Obviously, you may not be certain if you will be in a higher or lower tax bracket in 2010 or in retirement. If you expect to be in a higher tax bracket in retirement — perhaps because you have substantial savings in traditional IRAs, 401(k), and other tax-deferred accounts, you expect a hefty company pension, or you expect Congress to increase tax rates — then you may prefer to convert funds to a Roth IRA in 2010, 2011, and later before you hit the higher tax rates in retirement. If you expect to be in a lower marginal tax bracket in retirement — perhaps because you have modest savings and do not expect a company pension — then you should probably not convert funds to a Roth IRA. While it is not uncommon for people to expect to be in a lower tax bracket in retirement (when they are no longer receiving wages or other employment income), the inclination may be to abruptly conclude they should not convert funds during their working years to a Roth IRA. Beyond the straight comparison of income tax rates now versus later, there are several other factors to consider.
For additional details that should be considered when deciding whether a Roth conversion is right for you, see Reichenstein, Rothermich, and Waltenberger, " New Roth Conversion Opportunities: Is Converting a Traditional IRA, 403(b) or 401(k) a Smart Move, Unwise or Much Ado About Nothing?" Like this paper, that study explains why the major factor affecting most people's decision to convert funds to a Roth should be the comparison between their marginal tax rate in 2010 (or before retirement) and their expected marginal tax rate in retirement. If these tax rates are the same or similar then it discusses other factors that should be considered, many of which favor conversion to a Roth IRA. The study also discusses other details of the tax code that may affect the conversion decision. It explains a special option that can affect the payment of income tax on Roth conversions made in 2010 and why we recommend that most people ignore this option. The study details why the optimal conversion decision may not be to an all-or-nothing decision — but rather, a series of smaller conversions over time (if you conclude converting makes sense). Finally, it discusses details of implementing Roth IRA conversions, and the unique feature associated with a Roth IRA conversion that allows you to undo a conversion before your tax return for that year is due when or if the conversion proves to be undesirable.
Find a financial planner who can help determine whether it makes sense for you to do a Roth IRA conversion.