Roth IRA Conversion - Not a Good Decision

The Roth IRA 2010 Conversion Dilemma – Don’t Do It

In 2010, anyone with a traditional IRA can convert that account to a Roth IRA without having to comply with existing IRS limits for adjusted gross income. Right now, that income limit is repealed for 2010.
There is a strong temptation to want to do this. A Roth IRA allows you to accumulate assets for retirement with no future income tax consequence - no ordinary income tax on dividends or interest; no capital gains and losses are recognized; there is no required minimum distribution at any age; and the ability to “stretch” the Roth IRA across multiple generations still exists.
Great! Right?
Can you pay the income tax on conversion? Traditional IRA distribution rules still apply when you convert, except there is no 10% penalty for the distribution if you are under age 59 ½. You can spread the tax payment across 2 tax years.
Say you don’t mind paying the conversion tax. OK, and then is it a good financial decision?
The answer is a flat out no - not at any age and not at any tax rate up to 52%.
A large segment of the population has saved for retirement through tax qualified plans such as a 401k; they might also have been participating in a profit sharing plan. They have probably built up a substantial amount of deferred tax liability prior to and after the Roth was introduced in 1998.
When you leave an employer, your tax qualified plan balance is usually rolled over into a traditional IRA along with all of its deferred tax liabilities so you don’t incur a 10% premature withdrawal penalty if you’re under age 59 ½ or income tax on the principal.

To illustrate:

You’re 55 years old and have an IRA worth $500,000. The conversion puts you in the highest marginal federal tax bracket – 35%, plus (if you live in NY) 7% for state taxes. Total conversion tax - $210,000.
You’re still more than 15 years away from taking a required minimum distribution (RMD) if you stayed with the traditional IRA. The RMD would start at around 3.8% at age 70½ rising gradually to be more than 9% when you’re in your 90’s. That’s a long way from today when you are 55.
In the diagrams that go along with this discussion you will see why converting to a Roth is not financially sound.
Using the time value of money, let’s employ a 7% opportunity rate to compute the present value today of the future tax liability on RMDs from the time you’re 70 ½ to age 95. Today’s account balance of $500k has been advanced forward to age 70 ½ by 7% as well, to a value exceeding $1.5 million. That’s a lot of tax deferred growth, would you say?
The stream of tax payments beginning at age 70½ totals $941,037 through age 95. It has a present value cost today (age 55) of $132,414 using your normal combined marginal tax rate of 33% and the opportunity rate of 7%.
The conversion tax is $210,000. By itself, the higher lump sum payment compared to the present value of the future taxes, a difference of $78,000 suggests not converting.

You may have some difficulty with my analysis for not using the same marginal tax rate during the RMD phase as I did with the conversion tax. O.K., let’s see if that makes a difference. No. While the future tax payments will be in excess of $1.2 million, the present value today is just $168,881, still more than $40,000 below the conversion tax.

However, this is not the true economic cost. By removing $210,000 from your investments now might deprive you of the potential for nearly $3.1 million in investment gains over the next 40 years. Whereas the benefit from the future value of the tax payments that can be invested are approximately $1.9 million at the 33% rate and $2.45 million at the 42% rate results in a net conversion cost on nearly $1.2 million and $.7 million, respectively.

Why is the conversion cost so high? When you owe a debt to someone waiting as long as you can to pay it makes it less expensive. In this case, the future taxes you owe Uncle Sam on your IRA withdrawals are not coming due for many decades into the future. Therefore, on a present value basis the payments are cheap compared to forking over $200 grand to the government in 2010. Plus, converting a large IRA will put you in a higher tax bracket then when you wait to take required distributions after age 70 1/2 making the conversion cost even higher.

Just for the heck of it. What is the highest future marginal tax rate before a conversion has an economic benefit? 52%. This may happen with the pending “America’s Affordable Health Choices Act of 2009”. But, how many of you are likely to be in the top bracket then?