Notes on Roth IRA Conversion

February 9th, 2012 by KTU | Filed under Notes on Approaches.

THIS POST HAS NOTHING TO DO WITH DESIGN AND CONSTRUCTION. However, I spent a lot of time figuring ¬†out whether a Roth IRA conversion makes sense. I found complete junk on the internet. Here is my attempt to explain the rationale for conversion in case there are others out there searching for some logical arguments. I put this information in this blog, as I don’t have a better place for it.

These notes explain why, fundamentally, this conversion is beneficial. This is for the financially and mathematically sophisticated investor. If you don’t even know what a Roth IRA is, then go read the Motley Fool guide or something.

First, consider the very basic situation is which your tax rate today is the same as your tax rate in the future. For concreteness, assume your total tax rate is 40% (assuming for instance, a 35% federal rate and a 5% state rate and a state with policy similar to the federal). Assume your total long-term capital gains tax is 25%, now and in the future.

Assume also that you have $100,000, which were contributed with pre-tax funds, in a conventional IRA.

Assume also that you have $40,000 in after-tax funds available for investment. These funds are a reserve you have set aside to pay taxes.

If you stick with the conventional IRA, you leave these investments where they are until liquidation. Assume that you invest in a way that results in any investment increasing by a factor of 10, all very tax efficiently (e.g., all long-term capital gain). A 10x return would, for instance, correspond approximately to an 8% annual return for 30 years.

At liquidation, you would have, before paying taxes, $1,000,000 in the IRA and $400,000 in the after-tax side investment. Then, you pay the taxes and you are left with $600,000 from the IRA, and you’re left with $310,000 from the after-tax side investment. (You lose $90,000 because you pay a 25% long-term capital gain tax on the $360,000 in gain you got on that side investment). Your total after-tax proceeds are $910,000.

Now, consider what would have happened if you had done the Roth conversion.

First, you would send the $40,000 in after-tax funds to the tax collector. (This is the painful part.) Then, you would invest the $100,000 tax free. At liquidation you would have $1,000,000 with no tax due. Compare this to the $910,000 you would have with the conventional IRA.

Thus, in this example the Roth is about 10% better even when you assume the tax rate today and in the future are the same. However, this is only true if you have after-tax funds available to pay your taxes now. If you pay taxes from the pre-tax funds, the investments come out exactly the same.

Huh? How can it matter whether you pay the taxes from the proceeds of the IRA or from after-tax dollars? The reason it matters is that in the first scenario — staying with the conventional IRA — even though you have set aside 40% of the value of your IRA to pay future taxes, you will pay a capital gains tax on the growth in those funds that allows them to remain at 40% of the value of the IRA. That will reduce your value by $90,000 in the future. However, in the case of the Roth conversion, you pay only the $40,000 in taxes, and essentially you get the benefit of the future appreciated value of these funds (which have already been paid to the IRS) tax free.

Of course these factors make the Roth even more attractive:

- Any increase in future tax rates.

- The benefits of no-minimum distributions, as exist with conventional IRAs, and the ability to bequeath the funds to heirs tax free.

These factors would diminish the value of the Roth conversion:

- Lower future tax rates, as could occur if the U.S. went to a VAT tax or federal sales tax, or if you believe you will fall to a lower tax bracket with lower marginal rates.

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One Response to “Notes on Roth IRA Conversion”

  1. Steve Hoge says:

    Here in Colorado we get an extra break which makes a Roth conversion even more attractive, assuming you convert it over time instead of in a single big taxable event.

    The 1st $20K distribution from a retirement fund (eg, distributing the trad. IRA to fund the Roth ) is free of state tax – that’s an extra 5% effective gain! So I’m liquidating the IRA in $20K chunks over the next 15 years and using that to fund the Roth.

    Dribbling the conversion out over time also helps stay within a much lower combined Fed+State tax bracket (yeah, we stay way below 40%) than if we took it all at once.

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