More on the Roth conversion trap

In my last post on Roth conversions, I assumed the taxes for the conversion would be paid out of the IRA. An astute reader then asked how it would look if taxes were paid from savings outside of the IRA. I thought it was a great question and I immediately went to work looking for an answer.

To answer the question I considered two options:

Option 1: Do nothing. We keep the traditional IRA and invest the taxable savings we otherwise would have used to pay taxes.

Option 2: Convert a traditional IRA to a Roth IRA and pay the taxes for the conversion from a pool of taxable savings.

My standard for evaluation was simple. Whichever option produced the most overall wealth, would be the superior strategy. If you want to wade through the details of my analysis, please feel free to download a copy of my spreadsheet.

In Option 1, the investor keeps all of her money (inlcuding her taxable investments) working for her, but she faces future tax liabilities. Under Option 2, the investor pays taxes today in exchange for not having to pay any more taxes in the future--the well-known benefit of a Roth IRA.

To compare these options we need to project the value of each option to a common point in the future using identical return and net distribution assumptions. In my analysis, I assume that the investor has 20 years before retirement and that she will live another 30 years beyond her retirement date. I assume further that the IRA portfolios grow at a 10% rate and that the taxable portfolio will also be invested to earn 10% before taxes. With further assumptions about portfolio turnover, the nature of the capital gains generated by the turnover, and capital gains tax rates, I can calculate a reasonable estimate for an after-tax return on the taxable portfolio. Here are my assumptions:

• Portfolio turnover = 25%
• Percent of gains that are long-term = 67%
• Percent of gaines that are short-term = 33%
• Tax rate for long-term capital gains = 25%
• Tax rate for short-term capital gains = 45%

TAX-ADJUSTED RETURN = 9.21%

The mathematical formula to calculate this adjusted return is a little too convoluted to present here, but you can check it in the spreadsheet if you want to get into the nitty-gritty. Suffice it to say that capital gains taxes will probably reduce the pre-tax earnings by about 0.79 percent per year on the taxable portfolio.

Under Option 1, the investor keeps $100,000 invested in her traditional IRA and $45,000 invested in her taxable account. After 20 years the traditional IRA grows to almost $673.000 and the taxable account grows to $286,143. Once in retirement, I assume the investor begins taking a 5 percent annual distribution immediately from her IRA. Between the 10 percent return earned by the IRA's investments and the 5 percent annual withdrawal rate, the IRA grows to be worth $2.9 million after 30 years of retirement. The taxable account is also growing. By the time retirement ends, it is worth $3.7 million. The investor's total wealth position under Option 1 is therefore $6.6 million.

 

Now consider Option 2. In this case, the investor converts $100,000 today into a Roth IRA, pays the taxes out of her taxable savings and never pays tax on the Roth money again. As with Option 1, the Roth assets are invested to earn 10 percent so the balance grows to be almost $673,000 by the time the investor retires. In retirement (to make sure we look at both options on an equivalent basis) the investor takes annual withdrawals from her Roth  equal to the after-tax distributions realized by the investor under Option 1. In this case, after 30 years in retirement, the Roth IRA is worth just under $6 million. In other words, using these assumptions, the Roth conversion destroyed almost $600,000 in investor wealth.

To be fair, there are circumstances in which the Roth conversion might add value to the investor. For example, if the investor's marginal tax rate in retirement were equal to her tax rate today (i.e., 45 percent), Option 2 would beat Option 1 by $293,000 after 30 years of retirement. As you play with the spreadsheet you may find others situations where the Roth conversion makes sense. However, in most circumstance and for most people, a Roth conversion is a seriously bad idea.

Comments

[Mike Leavy]

Steve, when you evaluate the total wealth at the end of retirement, are you considering that the traditional IRA will be taxable to the heirs as the assets are distributed, whereas the Roth will not? It seems to me that the only time the "total wealth" value of the traditional IRA should not be discounted for the imbedded tax liability is if the investor intends to give the IRA assets to charity upon death, in which case the imbedded income tax liability is erased. Additionally, it is my understanding that if estate taxes apply, the value of the any traditional IRA assets in the estate is counted at its full value in calculating the value of the estate for estate tax purposes, so that by retaining the traditional IRA you are effectively paying estate tax on the imbedded tax liability. If you have previously converted to a Roth, those taxes will be out of the estate and estate taxes will be lower. I believe an additional benefit of a Roth is that there is no required minimum distribution, so investors not needing to draw from their retirement assets can continue to let Roth assets grow tax free, and then pass those assets along to their heirs.

[Steve Merrell]

Hi Mike-

Thanks for the comment. You raise some excellent points. My analysis does not consider estate tax consequences or other estate planning ramifications. To the extent that you are pretty certain you will pass the wealth to your heirs, you definitely want to think carefully about the issues you raise. Please note that extending the analysis to the heir includes projecting the heir's tax rate. Sounds kind of dicey to me. If the heir's tax rate is lower than the person doing the conversion, the conversion reduces her wealth, too.

In regards to estate taxes paid on the IRA balance, you are opening a very tricky area of the tax code dealing with something call "Income in Respect of a Decedent" or IRD for short. I'm not a tax expert and when I come across anything that smells faintly of IRD, I always call in a tax expert. At the risk of over-simplifying, the estate tax paid on an inherited IRA is usually deductible against the heir's income taxes. Again, this is a tricky area and requires a real expert to make sure it is handled properly.

Steve