As more baby boomers enter retirement, many are thinking about how to manage their taxes once they start taking money from their 401(k) and other retirement plan assets. As a refresher, money you take out of your traditional retirement plans (401(k), IRA, etc.) is generally subject to ordinary income tax rates. Depending on your taxable income, those rates can be as low as 10% to over 40% for high income earners once you combine federal and state rates.
With income tax rates potentially taking a big chunk out of your retirement distributions, many investors want to know if they can convert to a tax-free Roth IRA account. Once the money is in a Roth, it grows and can be distributed free of income taxes, if you follow all the rules. While there are income limits if you want to contribute to a Roth IRA, anyone can convert a regular IRA account to a Roth regardless of their income.
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Charlie Farrell
The tough part is that to move the money from your traditional IRA into the Roth IRA, you must pay income taxes on the money you convert. That means you must weigh the current tax cost to convert against the future value of tax-free growth. While this sounds complicated, there is a simple answer.
If your tax rate when you convert will be the same as the tax rate that applies to your IRA money when you eventually take it out in retirement, it doesn’t matter if you convert or not. You will end up with the same amount of money.
Here is an example. Let’s say you have $100,000 in an IRA and your combined Federal and state income tax rate is 25%. Let’s also assume the money will grow 6% a year for the next 20 years. If you leave the money in the regular IRA and it grows at 6%, it will be worth $320,713. Now if you take out all the money and pay 25% tax on it, you’ll be left with $240,535.
Compare this to moving the $100,000 from the regular IRA to the Roth IRA today, and paying 25% tax on it. Then let the $75,000 that’s in the Roth IRA grow for 20 years at 6%. In this case, you’d end up with $240,543 in the Roth. Essentially the same after-tax amount as you received from your regular IRA. If your tax rates are the same, it doesn’t matter if you convert. You will end up with the same after-tax amount of money.
Now, if you use cash that you have outside of your IRA to pay the tax bill owed on the money you convert to a Roth, you may end up slightly ahead, but not by much. The reason is you gave up 20 years of growth on the “outside” funds you used to pay your tax bill. Instead of giving the money to the IRS, you could have invested it. That cost needs to be included in your analysis. Thus, a conversion primarily comes down to whether you’ll be subject to higher rates later.
If you believe you will be subject to a higher income tax rate down the road, then you have a compelling case to convert. For instance, if you are subject to a 25% rate now and you think you will have to pay 30% later, then it makes sense to convert today at 25%. You will save 5%.
The hard part is that if you convert a large portion of your regular IRA in any one year, it may push you into a higher tax bracket. For instance, if you converted a $500,000 IRA, you’d have $500,000 of taxable income and likely be in the highest income tax bracket.
An alternative strategy is to convert the amount that keeps you in a lower income tax bracket each year. For instance, if you are married, you pay a federal income tax rate of 22% for income between about $81,000 and $173,000. Let’s say your income this year is $120,000. You could convert approximately $53,000 and remain in the 22% bracket. If you do this for 10 years, you’d convert over $500,000.
Again, this is advantageous if you think that later you’ll be subject to a higher income tax bracket. The other reason some investors convert is because they want to lock in a lower rate today and take the risk off the table that they’ll be subject to higher rates later. If you are not subject to a higher rate later, then you are no worse off, unless of course income tax rates drop; but that’s unlikely.
Roth conversion calculations are tricky, so you want to ensure you know all the rules. For instance, there is a five-year rule for withdrawals that may subject you to income taxes. Before you convert or withdrawal any funds, be sure to check with your tax adviser.
Charlie Farrell is a CEO of Northstar Investment Advisors LLC. This article is for information and education purposes only. Past performance is no guarantee of future returns, and all investing involves the permanent risk of loss. Consult your individual financial adviser for guidance specific to your circumstances.