When deciding whether or not to convert a traditional IRA to a Roth IRA, many investors overlook the fact that the goal is not to minimize the amount of tax dollars paid. Rather, the goal is to maximize the ending value of the portfolio.
What Am I Talking About?
Let’s consider a simplified example. Imagine that an investor has a choice between paying a 25% tax on her portfolio right now or in three years. And let’s say that her portfolio earns the following annual returns over those three years: +8%, +17%, +20%.
- If she pays the tax right now, the math will look like this: Ending value = beginning value x 0.75 x 1.08 x 1.17 x 1.2.
- If she pays the tax at the end, the math will look like this: Ending value = beginning value x 1.08 x 1.17 x 1.2 x 0.75.
Note that, due to the commutative property of multiplication, the ending portfolio value is the same in either case–even though the investor will pay more tax if she selects option #2 (because her portfolio value will be higher at the time she pays the 25% tax).
The same analysis applies for Roth conversions: The amount of tax paid doesn’t matter. What we care about is the ending portfolio value.
Roth Conversion Scenarios
Admittedly, this is something of an oversimplification, but Roth conversions can be roughly broken down into three scenarios:
- You plan to pay the tax on the conversion out of the IRA (rather than with money from a taxable account), and you’re over age 59.5
- You plan to pay the tax on the conversion out of the IRA, and you’re under age 59.5, or
- You have enough money in taxable accounts to pay the tax without having to use money from the IRA.
Paying the Tax from the IRA
In the simplest scenario–the one in which you’re paying the tax on the conversion out of the IRA and in which you’re over age 59.5 (such that there’s no penalty for doing so)–things work out like this:
- It’s a wash if you expect your tax bracket to stay the same. The commutative property of multiplication tells us that multiplying by, say, 0.75 now as opposed to multiplying by 0.75 later makes no difference.
- It’s a good idea if you expect to be in a higher tax bracket later.
- It’s a bad idea if you expect to be in a lower tax bracket later.
In the second scenario–in which you’re under age 59.5 and paying the tax out of the IRA–things become slightly more complicated. We have to account for the 10% early withdrawal penalty. For example, if you’re in the 25% tax bracket and you convert a $40,000 IRA and withdraw $10,000 to pay the tax, the 10% penalty will be charged on that $10,000.
End result: You need to expect a higher tax bracket in retirement in order for it just to be a break-even decision. (Specifically, your retirement tax bracket must be at least 1.1-times your current tax bracket for it to make sense.)
Paying the Tax from a Taxable Account
In the third scenario–in which you’re paying the tax out of taxable funds rather than out of the IRA–things get trickier. We have to make assumptions about the after-tax rate of return that will be earned (if you choose not to convert) on the money that would otherwise have been used to pay the tax.
That said, in this last scenario, things usually (though not always) work out like this:
- If you expect your tax bracket to remain the same, there’s a benefit to converting. It’s essentially a way to use non-tax-advantaged money to increase the size of your tax-advantaged accounts.
- If you expect your tax rate to increase, converting is a good idea.
- If you expect your tax rate to decrease, converting is likely (though not necessarily) a bad idea.