When to avoid a Roth IRA conversion

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Dear Dr. Don,
The question involves converting a traditional IRA into a Roth IRA. I have held off on doing so for the following reason: I would think that even if tax rates increase by the time I retire (30-plus years), I would go from the highest tax bracket to a much lower one, considering that I am retired and not actively working. Am I wrong?
— Lawrence Elicits

Dear Lawrence,
You’re right, given the parameters you put on your current and future tax brackets. When you defer income by contributing to a tax-deferred retirement account, you subject the contributions and the investment earnings to income tax at your marginal federal income tax rate in retirement.

When you pay the income taxes upfront and have the money invested in a tax-advantaged retirement account, like a Roth IRA, qualified distributions in retirement are free of federal income taxes. Your contributions and investment earnings are tax-free.

With more than 30 years until retirement, even though the tax brackets are adjusted for inflation, you should see your marginal income tax rate rise with your income over time. If you are currently in the top bracket, then paying the tax upfront is expensive, and you’d expect your bracket to drop in retirement.

Let’s take a simple example. You’re in the 35 percent tax bracket this year. You fund a traditional IRA with a $5,000 pretax contribution. The alternative is to contribute $3,250 in after-tax dollars to a Roth IRA. Investment returns for either portfolio average 6 percent annually over the next 30 years. Now let’s assume your tax bracket didn’t fall in retirement and it remains at 35 percent.

Tax bracket of 35 percent
Traditional IRA Roth IRA
Contribution: $5,000.00 $3,250.00
Average return on investments: 6% 6%
Value after 30 years: $28,717.46 $18,666.35
Tax on distribution in 30 years at 20 percent: $10,051.11
Distribution net of taxes: $18,666.35 $18,666.35

The distribution net of taxes is the same for the two accounts. That’s as expected. Now let’s look at a second example, where the only change is that you’re in the 20 percent tax bracket in retirement.

Tax bracket of 20 percent
Traditional IRA Roth IRA
Contribution: $5,000.00 $3,250.00
Average return on investments: 6% 6%
Value after 30 years: $28,717.46 $18,666.35
Tax on distribution in 30 years at 20 percent: $5,743.49
Distribution net of taxes: $22,973.96 $18,666.35

The lower bracket helps you out, as you predicted, and you have a higher after-tax distribution in retirement with the traditional IRA than with the Roth IRA.

In general, Roth IRA conversions make the most sense when you’re in a lower bracket when contributing to the Roth than you expect to be in at retirement, you’ll be invested for many years, and you can afford to pay the income tax due from funds other than your traditional IRA. Use a Roth conversion calculator to help you decide.

One advantage of the Roth IRA over a traditional IRA is that it isn’t subject to required minimum distributions, or RMDs, over your lifetime. There are RMD requirements over the beneficiary’s lifetime. Still can’t decide? Talk to your tax professional.

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