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Neal Frankle
Neal Frankle
To Convert or Not to Convert

Many people debate the virtues of converting to a Roth now. Should your clients convert to a Roth IRA now?

June 18, 2009
by Neal Frankle, CFP

If you or your clients are over 70½ you might consider converting your traditional IRA to a Roth IRA right now.

A Few Good Reasons

The market has done a number on your client's IRA account value. Since your client must pay ordinary income tax on any amount they convert, low values mean lower taxes. A good thing.

As an added bonus, Congress passed a law in December 2008 lifting the requirement to take distributions from your client's IRA (for 2009 only). So if your client doesn't take their RMD (required minimum distribution) they will have lower taxable income. That means it's easier to qualify for the conversion (your AGI [adjusted gross income] must be less than $100,000 to convert). It also means the tax on the conversion might be lower.

So the stars are all aligned … but does that mean you should convert your traditional IRA to a Roth IRA?

The answer to this question really depends on your client's unique situation. It also depends on their ultimate goal. If their main goal is to accumulate wealth, this might indeed be the time to convert. I ran some numbers and concluded that (for the right person) it makes sense to convert.

Here is what I assumed:

  1. Your clients have $100,000 in an IRA and $35,000 in cash.
  2. Your clients are in the 35 percent tax bracket.
  3. If your clients convert, they will use the cash to pay the tax due.
  4. Your clients can earn five percent on their money in the IRA.
  5. Your clients can also earn five percent on the cash but since it's in a taxable account, your net earnings are reduced to 3.25 percent. (I know you can't earn five percent on cash right now. I'm using five percent so we can compare apples to apples and also because this illustration is for 20-years-plus. They never know where interest rates are going to be a year from now … do they?)
  6. Your clients are currently 70½ and if they decide to keep the traditional IRA as is, they will take out just the RMD amount and deposit that into their savings account.

Roth Conversion. It's simple. We use the $35,000 to pay the 35 percent tax on the conversion so it's gone. The Roth continues to grow at five percent. At the end of 20 years, the value of this account is a cool $265,000. NICE!

A

ROTH CONVERSION

 

Year

ROTH VALUE

Investment Value

End of Year Total

1 $100,000 $0

$105,000

2 $105,000 $0

$110,250

3 $110,250 $0

$115,763

4 $115,763 $0

$121,551

5 $121,551 $0

$127,628

6 $127,628 $0

$134,010

7 $134,010 $0

$140,710

8 $140,710 $0

$147,746

9 $147,746 $0

$155,133

10 $155,133 $0

$162,889

11 $162,889 $0

$171,034

12 $171,034 $0

$179,586

13 $179,586 $0

$188,565

14 $188,565 $0

$197,993

15 $197,993 $0

$207,893

16 $207,893 $0

$218,287

17 $218,287 $0

$229,202

18 $229,202 $0

$240,662

19 $240,662 $0

$252,695

20 $252,695 $0

$265,330

21 $265,330 $0

$278,596

22 $278,596 $0

$292,526

23 $292,526 $0

$307,152

24 $307,152 $0

$322,510

25 $322,510 $0

$338,635

26 $338,635 $0

$355,567

27 $355,567 $0

$373,346

28 $373,346 $0

$392,013

29 $392,013 $1

$411,614

30 $411,614 $2

$432,194

Now consider the alternative. Let's say we don't convert our Traditional IRA. Look at the chart below.

B C D E F G H
NO Conversion          
  RMD RMD AMOUNT Cash

Total

Year IRA Value Factor Gross 35000

 

Latent Tax Liability

Net After Tax

1 $105,000 27.40 $3,832 $38,628

$143,628

$36,750

$106,878

2 $106,418 26.50 $4,016 $42,494

$148,912

$37,246

$111,666

3 $107,723 25.60 $4,208 $46,610

$154,333

$37,703

$116,630

4 $108,901 24.70 $4,409 $50,991

$159,892

$38,115

$121,777

5 $109,937 23.80 $4,619 $55,651

$165,588

$38,478

$127,110

6 $110,815 22.90 $4,839 $60,605

$171,420

$38,785

$132,634

7 $111,517 22.00 $5,069 $65,869

$177,386

$39,031

$138,355

8 $112,024 21.20 $5,284 $71,445

$183,468

$39,208

$144,260

9 $112,341 20.30 $5,534 $77,364

$189,704

$39,319

$150,385

10 $112,424 19.50 $5,765 $83,625

$196,049

$39,348

$156,701

11 $112,279 18.70 $6,004 $90,246

$202,525

$39,298

$163,228

12 $111,889 17.90 $6,251 $97,242

$209,131

$39,161

$169,970

13 $111,233 17.10 $6,505 $104,630

$215,863

$38,932

$176,932

14 $110,290 16.30 $6,766 $112,429

$222,719

$38,601

$184,117

15 $109,038 15.50 $7,035 $120,656

$229,693

$38,163

$191,530

16 $107,455 14.80 $7,260 $129,296

$236,751

$37,609

$199,142

17 $105,567 14.10 $7,487 $138,365

$243,932

$36,949

$206,984

18 $103,359 13.40 $7,713 $147,875

$251,234

$36,176

$215,059

19 $100,813 12.70 $7,938 $157,841

$258,654

$35,285

$223,370

20 $97,916 12.00 $8,160 $168,275

$266,191

$34,271

$231,920

21 $94,652 11.40 $8,303 $179,140

$273,792

$33,128

$240,664

22 $91,082 10.80 $8,434 $190,444

$281,526

$31,879

$249,647

23 $87,202 10.20 $8,549 $202,191

$289,393

$30,521

$258,872

24 $83,013 9.60 $8,647 $214,383

$297,396

$29,055

$268,341

25 $78,517 9.10 $8,628 $226,958

$305,475

$27,481

$277,994

26 $73,814 8.60 $8,583 $239,914

$313,728

$25,835

$287,893

27 $68,922 8.10 $8,509 $253,242

$322,164

$24,123

$298,041

28 $63,859 7.60 $8,403 $266,933

$330,793

$22,351

$308,442

29 $58,650 7.10 $8,261 $280,978

$339,628

$20,527

$319,100

30 $53,322 6.70 $7,958 $295,283

$348,605

$18,663

$329,942

Column B shows “IRA VALUE” growing at five percent. It's reduced by the amount you withdraw to satisfy the RMD (Column D).

Column C shows the RMD factor. This is simply the number the government makes your clients use to determine the amount of their RMD. For example, in year one1, the factor is 27.4. To arrive at an RMD of $3,832 you would divide the balance — in this case $105,000 by 27.4. This is the amount your clients must take out in the first year — unless it's 2009 of course.

The cash is shown in Column E. Your clients deposit their RMD (net of tax) into that account and this, plus the prior total grows by 3.25 percent.

After 20 years, the total is $266,191. So they should definitely NOT convert … right?

Not so fast!

Remember that they've paid the tax on the Roth conversion and your clients haven't on the Traditional IRA. If your clients were to take all the money out of the Traditional IRA, they have to pay that tax.

Again, if your clients want to approach this question from the standpoint of capital accumulation, they have to look at how much money they'd have if they took all the money out of the Traditional IRA and paid their tax.

Now, truth be told, your clients don't really know when they'll pay that tax. Your clients could die and their grandchildren could inherit their traditional IRA and then their grandchildren could defer most of the tax for a very long time.

The only way to decide what to do is by making certain assumptions.

As you can see from the graph below, if your clients don't need the money and don't think they'll ever need the money, the Roth IRA is a good choice. Again, this is only if your clients approach the question from a wealth accumulation point of view. If they are looking at income, it's a whole other ball game.

You can see, even if your clients don't consider the latent tax liability, they'll have more wealth in Year 23 if they convert to the Roth IRA.

Conclusion

Bottom line? This calculation assumes that your clients have money outside of their Traditional IRA and can use that to pay the tax on their conversion. If your clients find themselves in that situation and their main objective is to grow their wealth rather than create retirement income — the conversion could be for your client.

But I think there is a more important takeaway. Your clients should never listen to anyone who makes a blanket statement about converting their IRA. There are too many variables and assumptions. The right answer depends on what your clients want to do with their money. It's just stupid to think that one solution fits everyone. For example, if your clients told me that their main goal was to maximize retirement income, my answer might be completely different.

Have you converted your IRA into a Roth? Are you considering doing so? Have I missed something that you think is critical in making the decision? Send me an e-mail.

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Neal Frankle, CFP, is the author of Why Smart People Lose a Fortune: 5 Steps to Restoring Your Wealth and Sanity. If you would like to receive updates on other topics of interest, please register for my free e-mail newsletter here.

The material in this article is general information and not meant to provide specific investment, tax or legal advice. Investing in the stock market involves risk.