Deciding between a traditional individual retirement account (IRA) and a Roth IRA can be difficult. Choosing when and whether to convert your IRA money to a Roth account can be even trickier. Experts usually recommend that investors compare their current and future marginal tax rates to make a decision, but future tax rates can be very uncertain and many investors wonder if they have made the right choice. Now investment giant Vanguard has a more precise answer. Here’s how calculating your breakeven point can determine whether a Roth conversion makes sense for you. A financial advisor can help you save for retirement and select investments that meet your financial goals. Find a qualified advisor today.
Vanguard finds the ideal inflection point for a Roth conversion
Typically, the rule of thumb is that Roth IRAs are most beneficial if an investor expects to be in a higher tax bracket in retirement, since Roth contributions are taxed at current rates and distributions are tax-free. As such, Vanguard experts say that “assessing the current tax rate and expected future tax rate is a good first step” in determining whether you should convert your retirement savings to a Roth account.
However, sometimes a Roth conversion can be beneficial even if your future tax rate decreases instead of increases. So instead of a simple comparison of tax rates, the company recommends performing a dynamic Break-Even Tax Rate (BETR) analysis to determine if a conversion is right for you. Calculating a BETR offers investors an approach that simplifies the decision-making process.
“If your future tax rate is equal to the BETR, conversion would make no difference,” Vanguard analysts explain. “Simply put, the BETR shows how far your tax rate would have to drop to make conversion undesirable.”
If an investor’s future tax rate is higher than a calculated BETR, a Roth conversion would generally make financial sense. Even if an investor’s future marginal tax rate is lower than it currently is, certain scenarios can reduce a BETR and make a conversion much more attractive than it would otherwise appear on a simple rate comparison. This can potentially save an investor thousands of dollars.
For example, if you can pay Roth conversion taxes from a taxable account, such as your standard brokerage account, the entire value of your IRA can be moved into the Roth account. By not paying the conversion tax on the IRA, but on other portfolio funds, you can significantly reduce your BETR. Vanguard calculates that, if an investor pays the current 35% marginal tax rate and expects to pay the same in retirement, the BETR could drop to 29.6% if they switch to a Roth and pay taxes from a tax-efficient portfolio. If taxes were paid on a fiscally inefficient portfolio, where the investor had to pay annual tax on the investment return, the BETR would drop even further to 23.5%. As a result, a Roth conversion suddenly becomes quite attractive.
Another scenario where a BETR analysis helps is when an investor’s traditional IRA contains a non-taxable basis. When traditional IRAs are converted to Roth IRAs, only the pre-tax balance is subject to income tax. Vanguard research shows that the larger the non-taxable basis, the lower the BETR, and the more beneficial a Roth conversion becomes. Likewise, when an investor opens a backdoor Roth and plans to contribute more to it over time, the BETR drops and a conversion becomes even more beneficial.
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How pension savers can benefit from this
SmartAsset: When Should You Consider a Roth Conversion? Vanguard has an answer.
Essentially, a BETR is the future tax rate at which the after-tax withdrawal value is the same in both a no-conversion and a no-conversion scenario.
For example, let’s say you are currently a high earner in the 35% marginal tax bracket and are considering a $100,000 Roth conversion. You still have 20 years until retirement, after which you expect to fall into the 24% tax bracket.
First, you calculate the no-conversion potential. You assume that your $100,000 can triple over those twenty years if you leave it in a traditional IRA, to $300,000. After deducting 24% in taxes, the final after-tax withdrawal value of your money will be $228,000.
Then you calculate the Roth conversion potential. Again, that same $100,000 can triple in twenty years. Now, however, you take the $35,000 you pay in Roth conversion taxes (from your tax-inefficient portfolio) and estimate that, taking into account annual taxes on interest and capital gains, that $35,000 would have doubled over that same period. As a result, the final after-tax withdrawal value after a Roth conversion would be $230,000.
Plugging these values into the Vanguard formula gives you a BETR of 23.3%: $300,000 * (1 – BETR) = $230,000.
Under a simple rate comparison, you wouldn’t do a Roth conversion because your current marginal tax rate of 35% is higher than your future tax rate of 24%. However, the BETR method indicates that this may be a good idea, as the future rate of 24% is still higher than the calculated BETR of 23.3%. Of course, if you were paying your Roth conversion taxes with the IRA funds and not from a separate brokerage account, the BETR would change and in that scenario a conversion could no longer make sense. This free tool allows you to consult a financial advisor who can help you weigh the options in your circumstances.
In short
SmartAsset: When Should You Consider a Roth Conversion? Vanguard has an answer.
Vanguard’s BETR analysis is a more accurate method for determining whether an investor should consider a Roth conversion. Because it is a dynamic number affected by different financial decisions, calculating a BETR number allows investors to capture potential tax savings that might be overlooked in a simple, traditional tax rate comparison. Depending on the individual’s circumstances, it may be helpful to speak with an expert who can help you navigate the tax complexities of a Roth conversion, but tackling a BETR analysis yourself can be a solid place to start the process. start.
Not sure if a Roth IRA or Roth conversion can help you save more for retirement? For a solid financial plan, consider speaking to a qualified financial advisor. SmartAsset’s free tool matches you with up to three financial advisors serving your area, and you can interview your advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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