HomeBusinessWe answer your questions about Roth IRA conversions

We answer your questions about Roth IRA conversions

– Kiersten Essenpreis

The latest tax report explored when it’s smart for seniors to convert taxable traditional IRAs to tax-free Roth IRAs. It prompted a flood of questions from Journal readers asking for more details, so we’ll discuss some of them.

Roth IRA conversions are not suitable for all savers. But they often make sense for people with large traditional IRAs, which many have because of rollovers from traditional 401(k)s.

The most important factor is the tax rate on the Roth IRA conversion amount versus the tax rate on the money at the time of withdrawal – tax arbitrage, if you will. If the rate upon conversion will be lower than the rate upon withdrawal, conversion is often a smart move.

What about “opportunity cost,” the idea that dollars used to pay conversion taxes miss out on investment growth? This is not a problem if the tax rates are the same for the contribution and the withdrawal. Although the conversion tax is paid earlier, it is also smaller, and the tax deferred on the traditional IRA grows as the funds grow.

Ed Slott, Roth IRA advocate and CPA, gives a simplified example: Jane and Fred each have traditional IRAs with $100,000. These are invested identically and double over a period of 10 years. The tax rate is 30%, so Jane pays $30,000 in taxes to convert to a Roth IRA and has $70,000 to invest. In the end, she has $140,000 to withdraw tax-free.

Meanwhile, Fred doesn’t convert and his pot grows from $100,000 to $200,000. But if he withdraws it, he will owe $60,000 in taxes. That leaves him with $140,000 after taxes, the same as Jane.

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What makes a Roth conversion smart or not is whether the tax rates vary. If Jane’s tax rate on a Roth conversion is 20%, but her tax rate upon withdrawal is 30%, she’s probably a winner. And if Fred’s tax rate on a conversion is 30%, but his tax rate upon withdrawal is 15%, that’s not the case.

Of course, evaluating a Roth conversion forces savers to guess the future. But sometimes that is not difficult, for example if a saver moves from a state with high taxes to a state with low or no taxes. The death of a spouse can also subject the surviving spouse to a “widow’s penalty,” leaving him or her as the sole filer with a higher top rate.

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