Paying for Your Roth Conversion

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It seems like a simple calculation. You make your best guess about your tax bracket in retirement. If it will rise, converting a traditional IRA into a Roth could be a good move. If it will fall, a conversion probably won’t pay.

But there’s another wrinkle in the conversion decision, which millions of investors are weighing now that the $100,000 income limit has been scrapped. The second critical question is: Where will you get the money to pay the conversion tax?

As most investors now know, a Roth can be better than a traditional IRA, or TIRA, because withdrawals in retirement will be tax-free, while money taken from a TIRA is taxed as income. But if you switch your money from a TIRA to a Roth, you have to pay income tax right away. So you face a tax bill either way. It’s a question of pay now or pay later, and it generally makes sense to pay tax when your bracket is lower rather than higher.

But how, exactly, should you pay the tax. The first instinct is to pay it out of the converted funds. If you’re in a 25% tax bracket and convert $10,000, you’d pay $2,500 in taxes.

Obviously, that leaves you with only $7,500 to put into the Roth. It will grow tax-free, but can it grow enough to overcome this initial setback?

That would depend, of course, on a lot of factors like investment returns and the number of years before withdrawals begin. But most experts warn that paying tax out of the converted funds is a crippling blow that makes the conversion a money loser in most cases.

The Roth IRA Conversion Calculator takes this into account. In the default example, the three bars show how a 28-year-old investor with a $10,000 TIRA might fare with three strategies. Currently, the investor is subject to a 25% income-tax rate and a 15% rate on investments, the long-term capital gains rate. The investor assumes he will have a 15% income tax rate in retirement.

At first glance, the conversion seems to make lots of sense. After the conversion, the Roth would grow to $172,000 by the time the investor reached 65, while the TIRA would grow to about $147,000.

But if you scan down to the definitions, you’ll see that the calculator assumes that some other source was used for the conversion tax payment, not the funds taken from the TIRA. In other words, the Roth started with the full $10,000 taken from the TIRA, rather than $7,500.

If it started at $7,500, it would grow to just $129,000 by the time the investor reached 65, while the TIRA would be worth $147,000, even accounting for the income tax paid at withdrawal.

For an apples-too-apples comparison, the calculator provides the yellow bar. It assumes that the investor did not convert, keeping the entire TIRA intact, and also investing in a taxable account the additional $2,500 saved by avoiding the conversion tax.

With this option, the investor is starting with $12,500 instead of $10,000, supercharging results. This TIRA-plus-taxable strategy produces $175,000, beating both the TIRA and Roth.

The TIRA-plus approach won’t always be the best. If you reverse the income-tax assumptions, using a 15% bracket in the present and 25% in retirement, the Roth conversion wins. It produces $172,000, the TIRA $129,000 and the TIRA-plus $146,000.

That’s because the initial tax hit is smaller — $1,500 rather than $2,500. The TIRA-plus therefore starts at $11,500 rather than $12,500, and it suffers a 25% tax at the end rather than 15%.

Experimenting with the assumptions can produce many different results. The key is to focus on the Roth and TIRA-plus, else you overlook the key question of how a conversion tax would be paid.

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