Think You Missed the Boat on Roth Conversion?

Tara Thompson Popernik

Tara Thompson Popernik (pictured) and Paul Robertson

Not likely. As long as you don’t expect to spend down all of your IRA assets, our research suggests that converting your traditional IRA to a Roth IRA can save you plenty on taxes. Conversion would have saved you even more before the American Taxpayer Relief Act (ATRA) took effect in January, but that’s water under the bridge now.

Why Convert?

Some tax-management strategies let you defer taxes while others let you avoid them. With a traditional IRA, you get to defer taxes on your contributions and on portfolio growth until you withdraw money from the account (required minimum distributions, or RMDs, begin at age 70½). At that point, you pay tax at your ordinary income-tax rate, not the lower rate that applies to qualified dividends and long-term capital gains.

When you convert a traditional IRA to a Roth IRA, you pay income tax now on the money you transfer in order to avoid paying taxes later. If you pay the tax with money from outside the IRA, more of your wealth will then grow in the tax-free environment of the Roth IRA, which is more beneficial than the tax-deferred environment of the traditional IRA. That’s the great benefit of conversion. There’s a secondary benefit, too: Because no distributions are required from a Roth IRA, you free yourself from RMDs that could push you into a higher tax bracket.

What Our Research Shows

Let’s consider the case of a 65-year-old investor who has $1 million in a traditional IRA and $435,200 in a personal investment account that he can use to pay the tax cost of conversion (Display). We assume that the assets won’t be spent for 20 years, so they can keep on growing. In order to make a fair comparison between the two strategies, we also assume that after 20 years, all accounts will be liquidated and taxes paid.

 The Benefits of a Roth Conversion Can Be Large

We estimate that, in the median case, the Roth IRA will have an after-tax advantage over the traditional IRA (plus taxable portfolio) of approximately $200,000 in today’s dollars. If the investor plans to stretch the IRA by leaving it to his children, they will inherit a far larger Roth IRA, which may never be taxed and can grow for additional decades. (When a Roth IRA is stretched in this way, the beneficiaries are obliged to take RMDs over time, which are free of income tax. However, the IRA may be subject to estate tax before it passes to the younger generation.)

This does not mean that everyone should convert to a Roth IRA. The strategy is not suited to investors who expect to spend down their IRAs or to pay a much lower tax rate in the future. Of course, changes in the tax code over the 20-year period, such as limits on the benefit of a “stretch” to younger generations, may reduce the long-term benefits of conversion.  

If you do decide to convert, it’s worth thinking carefully about timing. To spread out and potentially lower the tax bite, you could convert part of your traditional IRA in 2013 and another part in 2014, with a view to remaining in a lower tax bracket whenever you can.  

You should work with your tax professional to determine whether a Roth conversion would be right for you and, if so, how you might best execute it.

The views expressed herein do not constitute, and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.

The Bernstein Wealth Forecasting SystemSM uses a Monte Carlo model to simulate 10,000 plausible paths of return for each asset class and inflation, producing a probability distribution of outcomes. It projects forward-looking market scenarios, integrated with an investor’s unique circumstances and taking the prevailing market conditions at the beginning of the analysis into account. The forecasts are based on the building blocks of asset returns, such as yield spreads, stock earnings and price multiples. These incorporate the linkages that exist among the returns of the various asset classes and factor in a reasonable degree of randomness and unpredictability.

Tara Thompson Popernik is Director of Research in the Wealth Management Group, and Paul Robertson is a Senior Portfolio Manager, at Bernstein Global Wealth Management, a unit of AllianceBernstein.

3 comments

  1. 1) Converting a $1million IRA over 2 years will add $500,000 to your income each year. Not at all a good idea. The whole point of the conversion is to escape high withdrawal tax rates.

    2) While most of the rest of the article is correct, its basic analysis of the two accounts is wrong … “Some tax-management strategies let you defer taxes while others let you avoid them. With a traditional IRA, you get to defer taxes on your contributions and on portfolio growth until you withdraw money from the account. At that point, you pay tax at your ordinary income-tax rate, not the lower rate that applies to qualified dividends and long-term capital gains.”

    Misunderstanding the net effects of the accounts leads to all kinds of wrong advice. BOTH accounts allow you to avoid the the taxes that would be paid in a taxable account. The benefits are exactly equal. The tax shelter is permanent (not deferred for an IRA).

    See the deconstruction of the benefits in the spreadsheet. http://www.retailinvestor.org/Challenge.xls Detractors are challenged to provide their own deconstruction proving their assertions.

    The taxes paid on IRA withdrawals equal the future value of the original contribution compounded at whatever rate of return was earned by the investments. They are not a tax on profits earned in the plan. Think of the original contribution as a loan – that is never your own money. Like your best friend gave you $$ to invest alongside your own.

    The difference between the benefits generated by the accounts comes from the IRA”s second factor equal to the $$withdrawn multiplied by the difference in tax rates between contribution and withdrawal. http://www.retailinvestor.org/RRSPmodel.html

    • Tara Popernik Thompson

      The point of conversion is not to avoid high tax rates, since many US taxpayers will actually have a lower effective tax rate in retirement. The point is to shift a percentage of a retiree’s assets from a taxable and tax-deferred account to a tax-free account (see diagram). The Roth assets can remain in a tax-free account as long as the retiree lives, presuming he/she does not withdraw the assets for spending. This strategy effectively avoids future taxes on the portion of the taxable portfolio used to pay the taxes and, because there are no required minimum distributions from a Roth account, avoids future taxes on withdrawals that the retiree does not need to take.

      Yes, we agree that the conversion example we use would necessarily subject some of the converted IRA assets to the top marginal tax bracket, but as we demonstrate, there is still a benefit of the conversion (and in our example, we convert over one tax year). If instead, a 65-year-old married retiree with no other taxable income converted a $1MM account over two tax years, only the last $50,000 of conversion in each year would be subject to the highest tax bracket. Theoretically, the conversion could be drawn out longer to “run the brackets,” but at a certain point, the growth of the assets inside the IRA will trigger a higher total tax on converting 100% of the account than if the taxes had been paid at the higher marginal rate.

      Your analysis doesn’t account for the impact of the required minimum distribution on the IRA account. A retiree who takes an RMD from an IRA, but does not need the cash for spending, can reinvest the after-tax assets in a taxable portfolio, but will pay taxes on interest, dividends and realized capital gains annually. A traditional IRA can only defer taxes, a Roth IRA can avoid them by not forcing withdrawals that must be reinvested in a taxable portfolio. For retirees who don’t need the RMD for spending, Roth is the better solution because there no required minimum distributions during the account owner’s lifetime.

  2. I am glad I converted to my Roth in 2010 . The substantial tax hit was spread over 2 years and I have more than doubled my portfolio since then … Looking back I think it was a good move…Also, I love not having to keep track of so many trades for the IRS…. Smooth sailing from here!

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