|
Traditional IRA vs. Roth IRA Conversion Comparison
Roth IRA Conversions are currently somewhat of a hot topic in the world of personal finance. And perhaps for good reason. Changes to the tax code that may actually benefit individuals seem to be few and far between these days, and for some, a conversion from a Traditional IRA to a Roth IRA may offer worthwhile long-term benefits.
Since I’ve already added to the mountain of information available on Roth IRA Conversions in a previous article, this time I’m offering up a couple of examples.
Please keep in mind that these examples are generic in nature, and at best may help you decide if further exploring a conversion is worth your time. Using assumptions that are different from those used in the examples (length of time distributions last, future tax rates, annual rate of return, etc.) can significantly alter the outcome.
EXAMPLE 1
The following table holds the “Conversion Details” used to create a comparison between keeping money in a Traditional IRA vs. converting it to a Roth IRA. Please note that in this example, the Current Tax Rate and the Future Tax Rate are the same. [You can click here to get a quick look at the 2010 tax tables.]
|
Conversion Details
|
|
Amount Converted:
|
$100,000
|
|
Years Until Withdrawals Begin:
|
10 Years
|
|
Years Withdrawals Last:
|
20 Years
|
|
Annual Rate of Return Earned:
|
6%
|
|
Current Tax Rate:
|
35%
|
|
Future Tax Rate:
|
35%
|
|
Taxes Paid on Conversion:
|
$35,000
|
|
This table shows the comparison.
|
|
Traditional IRA vs. Roth IRA
|
|
|
|
Traditional IRA
(No Conversion)
|
Roth IRA
(Conversion)
|
|
1.)
|
Value at Beginning of Period
|
$100,000
|
$100,000
|
|
|
|
|
|
|
2.)
|
Value at End of 10 Year Period
|
$179,085
|
$179,085
|
|
3.)
|
Growth on Taxes Paid at Conversion
|
$51,313
|
$0
|
|
4.)
|
Sub TOTAL
|
$230,397
|
$179,085
|
|
|
|
|
|
|
5.)
|
Amount of Yearly Withdrawal
|
$18,950
|
$14,730
|
|
6.)
|
Taxes on Yearly Withdrawal
|
$6,633
|
$0
|
|
7.)
|
Net Yearly Withdrawal
|
$12,318
|
$14,730
|
|
|
|
|
|
|
8.)
|
Total Withdrawn
|
$379,002
|
$294,593
|
|
9.)
|
Total Taxes Paid
|
$132,651
|
$0
|
|
10.)
|
TOTAL NET
|
$246,351
|
$294,593
|
|
|
|
|
|
|
11.)
|
Advantage
|
|
$48,242
|
|
This table offers explanatory notes for the preceding comparison.
|
Explanatory Notes
|
|
Line 1.)
|
The amount to be converted from Traditional IRA to Roth IRA.
|
|
Line 2.)
|
Future Value of $100,000 at 6% per year after 10 years.
|
|
Line 3.)
|
If you convert from a Traditional IRA to a Roth IRA and pay the taxes with money from outside the IRA (recommended), that money will no longer be available to you. To compensate for this and make the example fair, we have to assume that if no conversion is made the $35,000 in taxes paid would otherwise grow and be available to you in retirement. Line 3 is the Future Value of $35,000 at 6% per year for 10 years in a taxable account (assuming the Current Tax Rate of 35%.)
|
|
Line 4.)
|
Total assets from which you can create a source of income.
|
|
Line 5.)
|
Annual payment/withdrawal you might expect to receive assuming a 6% annual return and payments spread evenly over 20 years.
|
|
Line 6.)
|
Taxes due on the annual distribution you receive assuming the Future Tax Rate of 35%.
|
|
Line 7.)
|
Net after tax payment to you = Annual distribution - Taxes due.
|
|
Line 8.)
|
Sum of all withdrawals over the 20 year time period.
|
|
Line 9.)
|
Sum of all taxes due on withdrawals made over the 20 year time period.
|
|
Line 10.)
|
Net after tax withdrawals.
|
|
Line 11.)
|
Given the listed assumptions, the potential advantage of either the Traditional IRA or the Roth IRA.
|
|
EXAMPLE 2
The following table holds the “Conversion Details” used to create the comparison between keeping money in a Traditional IRA vs. converting it to a Roth IRA. Example 2 uses information that is identical to Example 1 with the exception of the Current and Future Tax Rates. In Example 1, both the Current and Future Tax Rates were 35%. In Example 2, we go from a Current Tax Rate of 25% (before retirement) to Future Tax Rate of 15% (during retirement). [You can click here to get a quick look at the 2010 tax tables.]
|
Conversion Details
|
|
Amount Converted:
|
$100,000
|
|
Years Until Withdrawals Begin:
|
10 Years
|
|
Years Withdrawals Last:
|
20 Years
|
|
Rate of Return Earned:
|
6%
|
|
Current Tax Rate:
|
25%
|
|
Future Tax Rate:
|
15%
|
|
Taxes Paid on Conversion:
|
$25,000
|
|
This table shows the comparison.
|
|
Traditional IRA vs. Roth IRA
|
|
|
|
Traditional IRA
|
Roth IRA
|
|
1.)
|
Value at Beginning of Period
|
$100,000
|
$100,000
|
|
|
|
|
|
|
2.)
|
Value at End of Period
|
$179,085
|
$179,085
|
|
3.)
|
Growth on Taxes Paid at Conversion
|
$38,824
|
$0
|
|
4.)
|
Sub TOTAL
|
$217,909
|
$179,085
|
|
|
|
|
|
|
5.)
|
Amount of Yearly Withdrawal
|
$17,923
|
$14,730
|
|
6.)
|
Taxes on Yearly Withdrawal
|
$2,688
|
$0
|
|
7.)
|
Net Yearly Withdrawal
|
$15,234
|
$14,730
|
|
|
|
|
|
|
8.)
|
Total Withdrawn
|
$358,458
|
$294,593
|
|
9.)
|
Total Taxes Paid
|
$53,769
|
$0
|
|
10.)
|
NET
|
$304,690
|
$294,593
|
|
|
|
|
|
|
11.)
|
Advantage
|
$10,097
|
|
|
This table offers explanatory notes for the preceding comparison.
|
Explanatory Notes
|
|
Line 1.)
|
The amount to be converted from Traditional IRA to Roth IRA.
|
|
Line 2.)
|
Future Value of $100,000 at 6% per year after 10 years.
|
|
Line 3.)
|
If you convert from a Traditional IRA to a Roth IRA and pay the taxes with money from outside the IRA (recommended), that money will no longer be available to you. To compensate for this and make the example fair, we have to assume that if no conversion is made the $25,000 in taxes paid would otherwise grow and be available to you in retirement. Line 3 is the Future Value of $25,000 at 6% per year for 10 years in a taxable account (assuming the Current Tax Rate of 25%).
|
|
Line 4.)
|
Total assets from which you can create a source of income.
|
|
Line 5.)
|
Annual payment/withdrawal you might expect to receive assuming a 6% annual return and payments spread evenly over 20 years.
|
|
Line 6.)
|
Taxes due on the annual distribution you receive assuming the Future Tax Rate of 15%.
|
|
Line 7.)
|
Net after tax payment to you = Annual distribution - Taxes due.
|
|
Line 8.)
|
Sum of all withdrawals over the 20 year time period.
|
|
Line 9.)
|
Sum of all taxes due on withdrawals made over the 20 year time period.
|
|
Line 10.)
|
Net after tax withdrawals.
|
|
Line 11.)
|
Given the listed assumptions, the potential advantage of either the Traditional IRA or the Roth IRA.
|
|
As is the case with many things, these two simple illustrations seem to indicate that a conversion from a Traditional IRA to a Roth IRA may work for some, and not for others. Hopefully, this article will help you decide if a conversion is worth further consideration.
Here are some general observations:
- Time Frames - Although not plainly evident in the above examples, the longer the distributions last, the more the potential benefits of a conversion begin to stack up.
- Tax Rates - The closer your Current Tax Rate is to your Future Tax Rate, or if your Future Tax Rate is anticipated to be higher than it is now, the better the potential to benefit from a conversion. On the other hand, if your tax rate will drop steeply during retirement years (going from a 25% tax bracket to a 15% tax bracket is a 40% reduction in tax rate!) the potential benefits begin to erode, and it may be more advantageous to stay put in a Traditional IRA.
- Available Cash - If you don’t have the cash available to pay the tax bill from sources outside of the IRA, and you instead use IRA assets to pay the tax, the potential benefits of a conversion are almost always lost.
- Unknowns - Unfortunately, there are many. At the very least: we don’t know what tax rates will be in the future; we don’t know for sure how long distributions will last; we don’t know what you will or will not earn on the investments; and we don’t know if Congress will come back and tinker with current Roth rules.
- Partials - Not to further complicate the matter, but you don’t have to “convert” all of your Traditional IRA assets. Partial conversions are allowed. It may suit your needs and/or temperament to make a partial conversion
Although I do my best to consolidate information and report it to you in as few words as I can, Roth Conversions simply have too many moving parts to cover in a few paragraphs. If you’d like to take a closer look at how a conversion from Traditional IRA to a Roth IRA may or may not benefit you given your set of circumstances, please feel free to give me a call or send me an e-mail to arrange a review.
[Back to Top]
IMPORTANT: The examples in this article are strictly hypothetical and offered for illustration purposes only. They do not depict actual events, or the performance of any specific investment. Past performance is no guarantee of future results.
Independent Retirement Planning and Investment advice in Orlando. [GO]
|
