A Roth conversion is a strategy that involves transferring money from a tax-deferred retirement account, such as a traditional IRA (tIRA), to a tax-free Roth IRA. The main benefit of this strategy is that it allows the investor to pay taxes on the converted amount at their current tax rate, and avoid paying taxes on future withdrawals from the Roth IRA. This can be especially advantageous if the investor expects to be in a higher tax bracket in retirement, or if they want to avoid the required minimum distributions (RMDs) that apply to tIRAs after age 72.
However, a Roth conversion is not a one-time decision. It requires careful planning and monitoring of the tIRA balance and the tax implications of the conversion. One of the challenges that many investors face is that their tIRA accounts may continue to grow over time, due to market appreciation and ongoing contributions. This can undermine the Roth conversion plan, as it may increase the tax burden of the conversion and reduce the net benefit of the Roth IRA.
To illustrate this point, let us consider a hypothetical example of an investor who has a tIRA account worth $1 million, invested entirely in equities. The investor plans to convert the entire balance to a Roth IRA over a 10-year period, starting in 2024. The investor expects to be in the 24% tax bracket throughout the conversion period and in retirement. The investor also expects the tIRA account to grow at an annual rate of 7%, and the Roth IRA account to grow at the same rate after the conversion.
The table below shows the annual conversion amounts, the taxes paid, the tIRA balance, and the Roth IRA balance for each year of the conversion period.
Table
| Year | Conversion Amount | Taxes Paid | tIRA Balance | Roth IRA Balance |
|---|---|---|---|---|
| 2024 | $100,000 | $24,000 | $907,000 | $76,000 |
| 2025 | $100,000 | $24,000 | $813,490 | $162,120 |
| 2026 | $100,000 | $24,000 | $718,254 | $258,408 |
| 2027 | $100,000 | $24,000 | $621,192 | $364,997 |
| 2028 | $100,000 | $24,000 | $522,196 | $482,027 |
| 2029 | $100,000 | $24,000 | $421,150 | $609,649 |
| 2030 | $100,000 | $24,000 | $317,841 | $747,994 |
| 2031 | $100,000 | $24,000 | $212,151 | $897,204 |
| 2032 | $100,000 | $24,000 | $103,862 | $1,057,428 |
| 2033 | $103,862 | $24,927 | $0 | $1,136,363 |
As the table shows, the investor pays a total of $240,927 in taxes over the 10-year period, and ends up with a Roth IRA account worth $1,136,363. However, the investor also misses out on the growth potential of the tIRA account, which would have been worth $1,967,151 if no conversion had taken place. Therefore, the net benefit of the Roth IRA account is $169,212 ($1,136,363 – $967,151), which is less than the taxes paid.
This example demonstrates how continued tIRA growth can undermine the Roth conversion plan, and why it is important to consider the trade-offs between the tax savings and the opportunity cost of the conversion. Some possible ways to mitigate this problem are:
- Converting larger amounts in the earlier years, when the tIRA balance is higher and the Roth IRA balance is lower.
- Converting smaller amounts in the later years, when the tIRA balance is lower and the Roth IRA balance is higher.
- Converting only when the market is down, to reduce the taxable amount and capture the recovery in the Roth IRA account.
- Converting only when the tax rate is low, to reduce the tax burden and increase the net benefit of the Roth IRA account.
- Converting only a portion of the tIRA account, to maintain some tax diversification and flexibility in retirement.
Of course, these strategies also have their own pros and cons, and may not be suitable for every investor. Therefore, it is advisable to consult a qualified financial planner before making any Roth conversion decisions, and to review the plan periodically to account for changes in the market, the tax laws, and the personal circumstances of the investor.
Passionate about finance news and updates, I’m your go-to guide through the twists and turns of the financial world. With a knack for breaking down complex topics into bite-sized insights, I’m here to make finance accessible and exciting for you.