Roth Rules for Retirees: Does Age Matter?

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All this recent chatter about Roth conversions tends to dwell on the concerns of the well-off, which often means older investors.

Sorry, young people. You’re actually the best candidates for Roth IRAs. That’s because people with more investing years ahead of them are far more likely to find the math working in their favor, thanks to the progressive tax system and the snowballing effect of compounding.

With a Roth IRA, you get no tax deduction on contributions, but all withdrawals in retirement are tax-free, including the original contributions and investment gains. Traditional IRAs provide tax deductions on contributions if you meet certain requirements, but withdrawals are taxed as ordinary income.

There has been a lot of talk in recent months about new rules that took effect Jan. 1, allowing anyone to convert a traditional IRA into a Roth. Previously, only people earning less than $100,000 a year could do this. Obviously, much of the attention has focused on whether the over-$100,000 group should convert, which entails paying tax.

In most cases, the key factor is whether the investor’s tax bracket is lower when the conversion is done than when withdrawals are made. If it is, converting means paying tax at today’s lower rate to avoid tax at tomorrow’s higher one, and conversion probably makes sense.

But many older investors are in their highest earning years, and shoulder the highest tax rates of their lives. So, it’s likely they’ll be in lower brackets when withdrawing from their IRAs after retiring. For them, conversion would not pay. Why pay tax at today’s high rate rather than tomorrow’s low one?

But the picture is quite different for people in their 20s or 30s. Most people earn much less at the start of their working years than they will later, and their tax brackets are therefore lower than they will be later, possibly lower than they’ll be in retirement.

To see the effect, look at the Roth IRA Conversion Calculator. The default values show results for a 28-year-old who will retire at 65. The investor has $10,000 in a traditional IRA and expects investment returns to average 8% a year.

By converting, this investor could expect to have $172,000 at 65, versus $147,000 by sticking with the traditional IRA. Note that the investor would do best by keeping the traditional IRA and investing an additional $2,500 that would have to be spent on taxes in a conversion. This would leave him with $175,000 at 65.

But notice that the default values assume this 28-year-old is in the 25% tax bracket now and will pay only 15% at 65. Reverse that to 15% now and 25% later and the Roth conversion trounces both alternatives, $172,000 versus $129,000 and $146,000.

Put the investor in the same 25% tax bracket at both points and the conversion would still pay off.

If you play with the “investment return” variable, you’ll see something else: the larger the return, the more likely the Roth conversion would be the best option. While this is true for young and old alike, it’s especially meaningful for the young because they are more likely to get bigger returns by bulking up on stocks. Older investors tend to trim their stock holdings as they emphasize safety, reducing returns.

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