Many Roth conversions that look good on paper actually lose positions. That’s the implication of an article published in the September issue of the Journal of Financial Planning. The article, entitled “Net Present Value Analysis of Roth Conversions,” was written by Edward McQuarrie, professor emeritus at Santa Clara (California) University’s Leavey School of Business.
A Roth conversion transfers money from your tax-deferred account (401(k) or traditional IRA) to a Roth IRA, with taxes on the transferred amount paid in a lump sum. Since future withdrawals from your Roth IRA do not incur taxes, unlike the required minimum distributions (RMDs) of a 401(k) or traditional IRA, traditional financial planning advice is to make this conversion if you think your future tax rates will be higher than they are at the time of conversion.
McQuarrie doesn’t disagree with that reasoning, but points out how long it will take for those tax savings to be recognized. Because a Roth’s tax savings accumulate over many years, it’s important to analyze those savings in constant dollars.
McQuarrie’s article conducted just such a net present value analysis, using the portfolio’s appreciation rate to discount future tax savings. To illustrate what he discovered, let’s consider a hypothetical 72-year-old who undertakes a $100,000 conversion, paying the 22% tax that would be due under current IRS tax brackets.
If he didn’t make the conversion and left his money in his 401(k) or traditional IRA, he would instead pay a 25% tax on each of the RMDs he would receive in subsequent years (this assumes expiry of the 2017 period). tax cuts).
Paying a 22% tax instead of a 25% tax seems like a no-brainer. And there is indeed a reward. But according to McQuarrie, taxing 3% less on each year’s RMD takes a lot of time. To demonstrate this, he created a ledger that showed, for each subsequent year, the total tax payments up to that year, as well as the total tax savings realized by that time—all in constant dollars. The diagram below shows what he found:
As you can see from the graph, it takes many years for the conversion to pay off. That’s because the taxes from a Roth conversion are paid up front, while the tax savings gradually increase year over year in increasingly deflated dollars.
McQuarrie calculates that, in constant dollars, this retiree’s total tax savings from the conversion will most likely not exceed the prepayment until after his death. In fact, assuming this retiree dies within his life expectancy, his cumulative tax savings at death will be about $7,000 less than his upfront bill if he takes the Roth conversion at age 72.
In that case, the benefits of the Roth conversion will accrue only to that person’s heirs, who, if the conversion had not occurred, would have had 10 years after death to continue taking RMDs . Only after 26 years have passed since the Roth conversion, when the retiree would have been age 97, will the cumulative tax savings exceed the upfront tax bill, in constant dollar terms.
McQuarrie is quick to acknowledge that it is possible to construct other hypothetical examples in which the Roth conversion yields results much more quickly. For example, if the conversion can occur at a single-digit tax rate, and subsequent years’ RMDs would have had a much higher double-digit tax rate, then the risk-reward calculus shifts significantly in favor of conversion.
Even then, the payout from a conversion is uncertain. Imagine a near-retiree who made a Roth conversion at a 22% rate, expecting the 2017 tax cuts to expire in 2026, when the U.S. federal tax rate for his bracket is expected to return to 25%. But with US President-elect Donald Trump and Republicans taking control of both houses of Congress, it is likely that the 2017 tax cuts will be extended and this original reason for a Roth conversion will evaporate.
Changes in tax law are just one source of uncertainty about whether the Roth conversion will pay off. Another is how long you live and the tax rate your heirs would have to pay in the ten years after your death, during which they could otherwise have continued taking RMDs. Even without these sources of uncertainty, it will take many years for the Roth to have a positive payout.
McQuarrie likens a Roth conversion to a 20- or 30-year loan you make to the federal government, where the interest it pays on your loan is dependent on any subsequent changes in tax law and no guarantee that the loan will ever be repaid . paid off. Roth conversions certainly look a lot less convincing that way.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be reviewed. He can be reached at
More: People think $1 million is the magic number to start estate planning, but it is much lower
Plus: The best advice from a pension expert? Don’t retire.
