Converting traditional Ira or 401(k) accounts to a Roth IRA means that the funds are in the Roth IRA will not be subject to income tax when you finally take them out… Ever. The caveats are that you will have to pay income tax on your deductible contributions and earnings when the conversion occurs.
So should you do it?
This is one of those questions that may have one of the most significant impacts regarding the tax treatment of your future retirement funds.
For the younger individual this move actually may be advantageous to you especially if you assume that you are going to be making more money and be in a higher tax bracket later on in retirement.
Eat the taxes now while you’re in a lower tax bracket rather than eating the taxes later when you’re in a much higher tax bracket – that’s the logic of why you would want to utilize Roth funds for retirement.
So who exactly may benefit the most from converting their traditional IRA or 401(k) to a Roth IRA?
1.If you expect to be earning more money later in your career then you currently are now.
I would hope that most of you reading this would expect yourself to be in this position. After all I don’t think most of us think that we are going to be making less money in the future than we are now. If you do I suggest maybe finding a new career path?
So if we are making more money in the future and are going to be in a higher tax bracket then we currently are it would make sense to pay taxes now at a lower rate rather than paying taxes down the road at a higher rate.
2. If you expect tax rates to be higher in the future than they are now.
Piggybacking on the logic that lower taxes now are better than higher taxes later then the same goes for if you expect tax rates to go up in the future.
I don’t want to get political here but let’s be real, do you think Uncle Sam is going to decrease tax rates in the future? Yeah I don’t either…
3. If you want to diversify the tax treatment of your retirement funds.
Having Money in a Roth IRA that grows completely tax-free is quite advantageous. However having pre-tax funds in a traditional IRA or a 401(k) that are tax deductible is also quite advantageous as well.
Depending on your unique situation it may be beneficial to you to have both pre-tax money and after tax money for the funding of your retirement.
4. If you want the peace of mind of having a hefty tax burden behind you
There’s something to be said for having peace of mind knowing that a pretty hefty tax burden is behind you. Now whether that peace of mind is worth the large tax bill that’s due the year you convert to a Roth IRA is up to you.
What is the conversion tax that I will have to pay?
When making the conversion from traditional funds to a Roth IRA you will be taxed as if you received a distribution.
In a nutshell, this means that the deductible contributions you have made to the traditional account will be subject to tax when you convert to a Roth IRA in addition to any of the earnings you may have experienced.
The one caveat and benefit of the Roth IRA conversion is that you obviously will not have to pay the 10% early distribution penalty even if you’re under the age of 59 1/2.
It’s also important to note that any nondeductible IRA contributions that you have made will not be taxed during conversion because the money is considered after-tax.
Let’s look at an example shall we?
For this example we will assume that our friend Bill has $80,000 in a traditional IRA. Bill is 27 and wants to convert his money to a Roth IRA, good for Bill.
We will make the following assumptions when it comes to Bill:
- We will assume a rate of return of 7%
- his tax bracket when he converts from his traditional IRA to a Roth in 2017 is 28%
- his income tax rate in 2018 to retirement is 33%
- his retirement age is 62
- his income tax rate at retirement is 33%.
In Bill’s example we will look at two different scenarios. Scenario 1 assumes that Bill will convert his IRA in 2017. In Scenario 2 we will assume that that Bill does not convert his traditional IRA to a Roth.
In Scenario 1 Bill converts his Traditional IRA to a Roth IRA in the current year, 2017. Bill pays pretty hefty taxes upon the conversion of $22,400.
Looking forward to the year 2052 when Bill is 62, his total Roth IRA balance at retirement would be $854,127 and Bill would have to pay no additional taxes assuming his is eligible for a qualified distribution from his Roth IRA at the time.
Caveats to Roth Conversion that should be taken into consideration:
-Bill has to pay $22,400 in taxes the year of his conversion, that’s quite a hit that most people can’t quite take
-It is possible to spread the conversion out over a period of a couple years so that there isn’t a substantial tax hit all at one time
Bill felt that he did not need to convert his traditional IRA to a Roth IRA. Instead, he decided to leave his traditional IRA as is.
He paid no taxes in the current year, 2017, obviously because he didn’t convert his IRA. However, the real kicker comes at retirement when Bill retires and the true differences between the Roth conversion and no Roth conversion can be seen.
The Side Fund
Since Bill didn’t convert his traditional IRA and didn’t have to pay the $22,400 tax that he did in Scenario 1, let’s assume Bill created a side fund with that money and invested it throughout his working career and it earned 7%. Realistically, most people would spend some or all of this money but for our comparison purposes it levels the playing field between the two different scenarios.
This side fund would grow to approximately $125,000 after being taxed in addition to Bill’s IRA balance at retirement.
At retirement, Bill will have a traditional IRA balance of $854,127 which is the same as he had in the Roth IRA at retirement in Scenario 1. However, if took a lump sum distribution from his traditional IRA at retirement, Bill would have to pay nearly $281,862 in taxes and he would receive only $572,265 after taxes.
Caveats to not converting that should be taken into consideration:
-In all likelihood Bill probably won’t be taking an entire lump-sum distribution of his entire IRA once he reaches retirement so the tax burden will be more spread out through his retirement. Nevertheless the tax burden will still be there for either Bill or his heirs.
The Taxable Difference
Charts by Broadridge
As you can see from the figure above the converted Roth IRA balance at retirement is larger than that of the traditional IRA that wasn’t converted. Why is that you ask? The answer is taxes.
Look at the total taxes paid from the Roth Conversion in light blue (Scenario 1). Granted $22,000 in taxes during the year you convert to a Roth is nothing to scoff over but when you compare it to the nearly $340,000 of taxes paid from not converting in the light red color (Scenario 2) it seems like a case for converting to a Roth in this specific comparison.
Charts by Broadridge
As shown on the chart above, converting to a Roth IRA in 2017 would allow Bill to accumulate about $156,000 more than if he had not converted.
In English please…
End result: Converting to a Roth IRA for Bill in this specific case will give him more money at retirement. Although he would have to pay a pretty hefty tax bill for the year he converted, later down the road Bill will have accumulated more money when taking into account the tax bill.
So what does this all mean?
From the previous example and all the other blathering I’ve done previously what can we conclude about converting your traditional IRA to a Roth IRA?
Well first of all it’s not for everyone but you may want to consider converting if:
- you expect to be earning more money in the future
- you expect tax rates to be higher in the future
- you want to diversify the tax treatment of your retirement funds
- you want the peace of mind of having a substantial tax liability behind you
I would also be remiss if I didn’t include that you should be willing to pay the substantial tax bill during the year of conversion.
So if you fit the bill then a Roth IRA conversion may make sense for you. Pay taxes now, be tax free in the future and have the potential to be sitting on more money when retirement rolls around.
This is a hypothetical example intended for illustration purposes only, and does not represent the performance of any specific investment or portfolio, nor is it an estimate or guarantee of future value. The calculations above assume that earnings are compounded annually, and that distributions from the Roth IRA will be tax free. Investment fees and expenses have not been deducted. If they had been, the results would have been lower. When making an investment decision, investors should consider their personal investment horizons and income tax brackets, both current and anticipated, as these may further impact the results of this comparison.
The side fund tax rate is assumed to apply to the side fund that you would have if you don’t convert your traditional IRA to a Roth IRA (and therefore don’t have to use these funds to pay conversion taxes). This tax rate may differ from the tax rate that applies to your IRAs because, depending on the investments you choose, earnings on the side fund may be eligible for capital gains or other special tax treatment (for example, income from certain municipal bonds may be tax free), while IRA earnings are generally taxed only at ordinary income tax rates upon distribution. Taxes are assumed to be paid at the end of the year (as a result, initial deposit to side fund occurs at the end of the year).
This illustration assumes a fixed annual rate of return; the rate of return on your actual investment portfolio will be different, and will vary over time, according to actual market performance. This is particularly true for long-term investments. It is important to note that investments offering the potential for higher rates of return also involve a higher degree of risk to principal.
This information, developed by an independent third party, has been obtained from sources considered to be reliable, but Raymond James Financial Services, Inc. does not guarantee that the foregoing material is accurate or complete. This information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. This information is not intended as solicitation or an offer to buy or sell any security referred to herein. Investments mentioned may not be suitable for all investors. The material is general in nature. Past performance may not be indicative of future results. Raymond James Financial Services, Inc. does not provide advice on tax, legal or mortgage issues. These matters should be discussed with the appropriate professional.
Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2017