Roth Conversion – Good or Bad

Submitted by William Tolson on Sat, 2009-04-04 23:45

Mr. Carpenter and Mr. Slott somehow agree that – now is the time to turn your taxable IRA (TIRA) into a Roth IRA. I clearly understand their rational is that with the value of IRAs now being low due to the market fall, the taxes on converting will be less than they would have been a couple of years ago, and that the market will improve significantly so the future tax-free Roth account will be a relatively larger amount.

Unfortunately, their opinions “don’t compute” and I disagree. For the average person there is never a good time to convert an IRA to a Roth – at least from an account’s in-pocket, cash out value amount over time. While there may indeed be some estate planning virtues in converting to a Roth, from the amount of post-tax money available upon cashing in either of the IRAs, a Roth conversion is most often a big financial mistake for most people.

Why do I disagree with the “experts”? Because they have not realistically accounted for the future value of the Cost of Money (COM) used for paying the taxes on the conversion. They neglect to either specifically or realistically identify the future value of the COM and the bases for determining this value.

To determine if a Roth conversion is financially a good move requires an “industrial strength financial planning software program” that properly handles year-by-year taxes to accurately compare a Roth conversion vs. not converting. But even a simple assumption of a person’s income tax rates being relatively the same over a long period, shows the conversion is a big mistake for most people – if having the most money available in your pocket at a future date is the principal criteria.

Here is an example for myself. Assume the following. A regular TIRA of $500,000: a one-time tax rate of 45%, Federal + State, on the withdrawal for the conversion; a 15% Cap Gains tax on the COM (paid to the IRS for the conversion) profits of the money if it is invested in normal stock/bond equities, or 0% if invested in Munis; a combined Federal + State tax of 32% on normal income; and importantly, the investment growth rate for the IRA or Roth account being the same as for the COM investment account.

The above can be input to a simple Excel spread sheet, that shows the Roth conversion cash-out will be about $400,000 less in-10 years compared to not converting, and about $800,000 less after 20 years.

So it totally escapes me how Mr. Carpenter and Mr. Slott believe now, or any time, is good to convert your IRA into a Roth IRA.

Bill Tolson
310 373-4746
[email protected]



Submitted by Alan Spross on Sun, 2009-04-05 00:49

Bill,
I don’t think any of the experts are suggesting large dollar conversions of entire IRA accounts at marginal rates of 45% if the average rate in retirement is expected to be lower than that. More than likely, individual analysis of a taxpayer’s situation might recommend modest amounts converted at rates that do not increase the current bracket.

There are no conversion calculators that are able to address all the dozens of variables involved in the conversion decision. The main variables call for crystal ball estimates of future tax rates and future asset accumulation. The future tax rates will also heavily depend on the success of asset accumulation. With all these variables, it is wise to have some tax diversification in retirement accounts, ie have some portion in both Roth and pre tax vehicles so that all IRA assets are not subject to RMDs and so that a taxpayer can select which type of account should fund a particular withdrawal.

For example, for a large uninsured medical or long term care expense that is deductible, use the TIRA because the deduction will offset much of the distribution tax. If you want to buy a car, but do not want to have your marginal rate increase due to a distribution, use the Roth.

Today, only about 5% of IRA retirement assets are in a Roth account. That means the the public is not well diversified between the two types of accounts and in combination of projected tax rate increases due to the exploding deficit, there are many who should be increasing their Roth allocation now before tax rates increase.

I agree that Roth conversions can be overdone but for every taxpayer that has converted too much for their situation, there are probably dozens who have too little in Roth accounts. The bottom line is that a Roth hedges against the tax on success while the TIRA hedges against poor future financial prospects. In other words, if you are going to convert and then leave the Roth in MM funds or low paying CDs, then the conversion taxes may well be better off saved.



Submitted by William Tolson on Sun, 2009-04-05 01:25

Alan

Exept for the minmum rate of 10%, what rate is less than the 15% on CG, at least for now? How can someone converet for a 15% tax on the converson cash-outs not be to their advantge? That is, a conversion stilll looks like a bad move, IMHO. The bottom line is I still think conveerting is a bad move for almost everbody – excuding those the think the estate planning issues are more significant.

Bill



Submitted by William Tolson on Sun, 2009-04-05 02:09

Alan You said —-
I don’t think any of the experts are suggesting large dollar conversions of entire IRA accounts at marginal rates of 45%.

Alan
Then why didn’t the say so – or identify/clarify when/where the conversions are not advantageous. Their comments implied conversions are good – for everybody!

Why didn’t they mention that if the taxes on the full/partial conversion are more the 15% GC rate, a conversion is a bad move??? For most people, the tax on the conversion will be far more than 15%.

I would think the purpose of an “advisor” is to illuminate the whys and why nots. This lack of information significantly lowers the credibility of the advisor.

I recognize the Slott and others give very important, probably accurate advice to various IRA and other type of planning questions, but they are far off-base about Roth conversions – in my opinion. I believe they should be saying Roth conversions are bad for most people – perhaps except for some most unusual situations.

Bill



Submitted by Bruce Steiner on Sun, 2009-04-05 03:01

Dave Carpenter is a journalist, not a tax lawyer. Given that he’s a journalist rather than a lawyer, I thought his article was a good one.

At a constant tax bracket, the Roth conversion always wins, assuming you have sufficient non-IRA funds with which to pay the tax on the conversion. For example, assuming a constant 30% tax rate, suppose you have a $10,000 IRA and $3,000 of other money. If you convert, you’ll have a $10,000 Roth IRA. Over some period of time, it grows to $20,000. If you didn’t convert, your $10,000 IRA would grow to the same $20,000, or $14,000 after taxes. If the tax rate on your investment income were zero, your $3,000 taxable account would grow to $6,000, so you’d have the same $20,000 total after taxes. But since the tax rate on your investment income is greater than zero (assuming some dividends or capital gains), your taxable account will grow to something less than $6,000.

The problem for many IRA owners is that if you convert a large IRA all at once, you’ll bunch the income into a single year. So you have to balance the benefit of converting all at once and getting more money into the tax-free Roth environment sooner versus spreading the conversion out over a number of years. Many IRA owners in that situation spread the conversion out over a number of years to avoid bunching the income (and also because they are often more comfortable with converting gradually since they feel that gives them the opportunity to stop at any point). IRA owners who are still working often wait until they retire to begin converting, since they expect to be in a lower bracket after they retire.

You are correct that many “advisors” are not familiar with the mathematics of the Roth conversion. But until now, given the $100,000 income cap, most clients have not been eligible to convert. Since the $100,000 income cap will no longer be in effect after 2009, I and others will begin to speak and write more about Roth conversions starting toward the end of this year. As a result, more “advisors” should become more familiar with the mathematics of the Roth conversion.

As Alan points out, there are a large number of variables, so that it is difficult to calculate this with precision. But you have to decide whether to (i) convert all at once, (ii) convert some each year, or (iii) not convert at all. You can make some reasonable assumptions and do an Excel spreadsheet, making sure to run it through the year in which your beneficiaries will take the last distribution out of your IRA (if you don’t convert) or out of your Roth IRA (if you do convert). You may also wish to discuss this with the attorney who handles your estate planning.

Bruce Steiner, attorney
NYC
also admitted in NJ and FL



Submitted by charles lore on Sun, 2009-04-05 14:56

Bill I’m not sure how you did your spread sheet but something is not adding up correctly. First when you do a quantitative analysis of a conversion you have to assume the tax rate on the conversion today is the same tax rate that you would be faced with in the future for the alternative scenario ( which is no conversion but you liquidate the TIRA on a horizon date to see what you have after tax). I’m sure you used the same tax rate but just wanted to get that out of the way.

When you have a TIRA and an outside account it really just boils down to how tax efficient do you want the outside account to be. You can do nothing ( not convert and pay taxes in the outside account and incur opportunity cost on the money sent to IRS each year ( you say COM ,I say opportunity cost and others may say time value of money) .. and pay your tax bill when you distribute TIRA n the horizon date.. OR you can..

Use the outside account to make that TIRA tax bill on the horizon date go away. That is to say convert today. and use that outside account to pay conversion tax bill. If you do the first scenario and keep the TIRA and the outside account…. if the outside account pays even 1 dollar in tax you’ll have less money than the conversion scenario. Simple math.

This is just a different way of saying what B. Steiner’s article said . Sure you can ask what about if tax rates change and what about stretching etc etc.. but those are qualitative issues. Right now I’m just addressing your spreadsheet.

Chuck



Submitted by Chuck Snyder on Sun, 2009-04-05 20:06

Everyone’s situation is unique. It follows then that there can be no rule that applies to all. Whether or not one should convert and if so how much to convert and when to do so must be evaluated in light of the circumstances of each individual.

Bruce said, “IRA owners who are still working often wait until they retire to begin converting, since they expect to be in a lower bracket after they retire.” I want to point out a potential pitfall that I am sure Bruce is aware of but neglected to mention and that is the taxing of Social Security benefits. I suspect there are many individuals and even some advisors that are not fully aware of the repercussions of this tax.

Due to the way that it is levied every dollar of benefits that is taxed narrows the particular bracket that one is in by a dollar. It also creates what I call EMRs (effective marginal rates). When one is the 10% bracket and you reach the threshold where SS begins to be taxed, for every dollar of other income 50 cents of SS is taxed. Consequently, your EMR is 15% (10% of $1.50). When you get to the 15% bracket, your EMR is 22.5% (15% of $1.50). In addition, when you reach the second threshold where 85 cents of SS is taxed for every dollar of other income your EMR is 27.75% (15% of $1.85). Should you still be paying tax on SS in the 25% bracket your EMR is 46.25% (25% of $1.85).

What I am attempting to point out is that those that choose to convert should if possible do so before receiving SS benefits. Those that retire before they are eligible for SS or put off taking benefits until later have an advantageous window of opportunity to convert.

Chuck Snyder



Submitted by William Tolson on Mon, 2009-04-06 01:25

Mr. Steiner and Chuck

First to Chuck – I don’t think it is realistic to assume the tax rate on the conversion will be the same as TIRA withdrawals. While it may be, it equally may not be the same – and this why some analysis program that permits differing inputs, or even better a program that does this for you, is useful. And generally, the longer you have a Roth, the better it is vs. the TIRA. So as you noted, those under the SS income age may find it prudent to consider the Roth sooner than later

I apologize. Here I complain about someone not clarifying the bases for their opinions – and I look in the mirror and find I did that myself.

So – most significantly, my comments about the accounts’ future values ASSUMED the funds used outside of the TIRA to pay the withdrawal taxes (COM) would have been invested in equities affording the gains to be taxed at the CG rate – currently 15%.

And lastly, I did assume the entire IRA was converted in one year, which dramatically increased the taxes on the conversion and obviously biased the results in favor of not converting.

That said, it is clear as you both said, if the tax rate on the conversion is about the same as on the withdrawals, the Roth looks good. Which means as Mr. Steiner stated, the portion of an IRA to be converted must consider ones existing tax rates.

Bill



Submitted by Bruce Steiner on Mon, 2009-04-06 04:42

I think we’re all closer to the same place than it seemed at first.

Chuck Snyder is correct that Social Security benefits can be a factor, and that each person has to look at whether to convert (and if so, when and how quickly) in light of his/her own situation. I didn’t mention Social Security because our clients are generally above the thresholds in any event, and because there is no practical way to mention every possible factor. Other factors that can be important in particular cases are state income taxes and the AMT.

And Bill is correct that another factor to consider is how the money used to pay the tax on the conversion would be invested if the IRA owner did not convert. One way to deal with this is to make an assumption as to the pre-tax rate of return in the IRA and the after-tax rate of return in the taxable account.

Of course, one cannot be certain as to future income tax rates. But you can make some reasonable assumption.

As to how to do the calculations, the possibilities include Microsoft Excel, Brentmark’s pension and Roth analyzer — see http://www.brentmark.com , and whatever software that accountants use to do projections for alternative scenarios (the BNA income tax spreadsheet — I think available from bna.com or bnatax.com — being one example, though I’m sure that some of the accountants in this group can suggest other programs).

Notwithstanding the above, I think it’s a fair statement (and hence a pretty good general rule) that to the extent an IRA owner can convert without pushing his/her tax bracket up by more than a modest amount, the conversion is likely to be beneficial.

f course, like anything else in this forum, this post is not intended as legal or tax advice. In other words, an IRA owner who is considering converting to a Roth IRA may wish to consult with the lawyer who handles his/her estate planning, as well as with his/her accountant, who can give him/her specific advice based upon his/her particular situation, and his/her objectives.



Submitted by William Tolson on Mon, 2009-04-06 19:34

Mr. Steiner

You noted —“Notwithstanding the above, I think it’s a fair statement (and hence a pretty good general rule) that to the extent an IRA owner can convert without pushing his/her tax bracket up by more than a modest amount, the conversion is likely to be beneficial.”

I concur; that is a good rule of thumb

And perhaps another FWIW rule of thumb is that a conversion will provide about 2.5% more in-pocket future year value money after 10 years, and almost 5% more after 40 years – if gains on the COM to pay the conversion withdrawal taxes are taxed at the current 15% CG rate. These percents would nearly double if the COM gains are taxed as personal income.

You also noted – “As to how to do the calculations, the possibilities include Microsoft Excel, Brentmark’s pension and Roth analyzer — see http://www.brentmark.com , and whatever software that accountants use to do projections for alternative scenarios (the BNA income tax spreadsheet — I think available from bna.com or bnatax.com — being one example, though I’m sure that some of the accountants in this group can suggest other programs).”

There are likely some sophisticated financial planning programs out there that will do (among many other analyses) the convert vs. no-convert comparison calculations, that handle the SS, Medicare, AMT, impact on one’s other incomes taxes without the added MRDs from a TIRA, and such mentioned by others – to fine-tune the comparison.

About 10 years ago I had such a program that I really liked, but they went out of business – probably because their results were in essence, and X-Y plot of asset/account $ for each future year rather than the Monte Carlo outputs (marginally useful IMHO) that most advisors now prefer. Hey, you can’t be criticized for not meeting a client’s 5-year goal if that goal is a +/- 25% range.

Bill



Submitted by george collins on Sun, 2009-05-10 17:01

Newbee to this forum; and impressed.

I am 63 retired and getting educated for my next Financial Planner visit; Considering converting 100 to 150k to Roths. ❓

my situation;
IRA, 400k , daughter beneficiary.
Roths 300k, wife benficiary, plan is to leave all to family
Revocable joint trust 1,500k.
home 1,500k
pension 110k + 10K/yr for next 6 years; back to 60k in 6; 35k survivor bene
SS suspended to 70(7 yrs) 50k combined(I understand SS tax fun and games)

questions:

If I convert 50k-10k/yr over the next 5 years, my income for the next 15-20 yrs will be fairly constant. With our government help the taxes should be higher in the future.
But since I plan on streaching the IRA to my daughter–why bother converting as My wife will have no MDR after my death.
2. Also, why do I need any life insurance as we have sufficient funds to cover income needs and gifting to reduce estate.
3. Should house be in Trust??
4. Wife could end up with only 35K taxable after my death, SS taxes nearly eliminated. ?

thanks in advance for any pitfalls, recommendations

jerry



Submitted by James Mitchell on Mon, 2009-05-11 04:20

“Another issue that I did not see addressed in this discussion is the impact on Medicare premiums for a large conversion by a person paying Medicare premiums. A large enough conversion can have a direct impact on the monthly premium one pays. It may be a temporary premium increase, but can be an increase.”

I did not know medicare premiums were tied to earned income. Is this true? How does that work?

Thanks, James



Submitted by James Mitchell on Mon, 2009-05-11 15:00

Good grief! I’m not surprised but I did not know this. When I first signed up for medicare, I did not give any income information. My wife just signed up for her own medicare last month and, once again, we did not supply income information. How do they do this? Do they use the previous year’s tax return data?

Thanks again



Submitted by James Mitchell on Mon, 2009-05-11 15:13

Sorry, I got lazy(er).. I should have just gone to the link you provided. Here’s what it says:

“How will I know if I must pay more?
If you are already receiving Social Security benefits and apply for Medicare Part B coverage, we generally will ask IRS to send us information from your most recent tax return two months before your coverage begins. We will then send you a letter to tell you what your premium will be and how we made this determination.

If you are not already receiving Social Security benefits when you file for Medicare and your coverage becomes effective at the time of filing, we will begin to charge you the standard premium amount. Then, we will ask IRS to send us information from your most recent tax return. If IRS data indicates you need to pay a higher premium, we will correct your Part B premiums back to the earliest time in the year you had Part B. We will then send you a letter explaining how we made this determination and what your new premium will be.

We will make any adjustments to the standard premium using a sliding scale. The sliding scale will be based on your modified adjusted gross income (MAGI). Your MAGI is a combination of your adjusted gross (taxable) income and tax exempt interest income. In 2009, if you file your taxes as “married, filing jointly” and your MAGI is more than $170,000, you will pay a higher Part B premium. For any other taxpayer filing status, you will pay a higher Part B premium if your MAGI is more than $85,000.”

It looks like joint filers will pay more if MAGI is greater than $170k. This would affect Roth conversion calculations much greater than $100k. The extra monthly cost is about $40 at $214k and is prorated. We each should visit the IRS website to get more specific information.

James



Submitted by Alan Spross on Mon, 2009-05-11 18:01

They use the return for the second prior year, eg. 2009 Part B premiums are based on 2007 tax returns. Your income this year will determine the 2011 Part B premium. Note that conversion income may increase your Part B premium two years after the conversion, however in later years when your RMD is reduced because of those conversions, your Part B premium could remain at a lower level.



Submitted by mk foss on Mon, 2009-05-11 21:03

Medicare gets information from the IRS on tax return filings and uses it to determine Medicare premiums. There is a timing gap – 2008 return does NOT affect 2009 premiums but a later year.



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