Roth IRA Conversion – Don’t Do It

Roth IRA Conversion – Don’t Do It
By Thomas Warren, CFP®
August, 2009
Are you considering converting to Roth IRA in 2010 when there are no IRS restrictions? If you decide to do so you are required to pay income taxes on the amount converted. This payment now of the taxes you would ordinarily pay many, many years into the future has a significant opportunity cost that you may not be aware of that makes converting a poor financial decision.
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.
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; there is no required minimum distribution at any age; and the ability to "stretch" the Roth IRA across multiple generations still exists.
Great! 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. 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 built up substantial amounts of deferred tax liability prior to and after the Roth was introduced in 1998. When these funds are rolled over to a traditional IRA all of the deferred tax liabilities are transferred as well, to be paid out in installments many years from now.
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.
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 of nearly $1.4 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 using your normal federal rate of 26% and 7% for the state, or 33% combined. These tax payments have a present value cost today (age 55) of $132,414 at the 7% discount rate.
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 avoided tax payments that can be invested in the future are approximately $2.0 million at the 33% rate and $2.45 million at the 42% rate. This results in a net conversion cost on nearly $1.2 million and $.7 million, respectively.
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?
Here we have another example of compounding - "the gift of time/the curse of time"; the payment of the lump sum conversion tax removes the potential to earn $3.1 million over the next 40 years, the curse of time; the taxes saved after age 70 ½ have a future value if invested of $1.9 million, but the investment term is only 25 years, the gift of time; however, the first 15 years does not have any investment or tax benefits, just an opportunity cost, that clearly makes the conversion decision a slam dunk no!