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Convert Your IRA to a Roth!

In 2010 everyone, regardless of income, will be eligible to convert their regular IRA money into Roth IRAs. Doing so will require paying taxes on the amount converted; i.e., the amount taken out of the regular IRA and put into a Roth IRA.

Currently, only those with adjusted gross incomes of less than 100K (single or married) are eligible to do the conversion. And those with higher incomes (110K for singles and 160K for married joint filers) are not able to contribute to a Roth IRA, although they can contribute to a Roth 401(k) if their employer has established such an account.

If your money is in a 401(k) plan, you may, with your employer's help, be able to roll over your 401(k) to an IRA and then in 2010 do the conversion. See http://www.kelseypub.com/blog/homefamily/2009-02-17/from-a-lousy-401k-to...

This case study shows a very large potential gain in living standard from exercising this option.

Basic Profile

Tom is 58, Janet is 58
Their children have already graduated from college.
Housing: 10 years remain on mortgage; 80K balance; 2K property tax; 1K insurance; monthly pmt: $1500
Retirement Plans: Tom 65, Janet 65: (year 2015)

Income Tom: 300K in today’s dollars, steady through age 65
Income Janet: 0 in today’s dollars, steady through age 65

Contributions Tom: 0.00
Contributions Janet: 0.00

Regular assets: 100K
Retirement Balance Tom: 500K in 401(k)
Retirement Balance in IRA: 300K
Retirement Balance Janet: 20K
Janet Pension: 7K in today’s dollars begin at age 59 100% indexed to inflation.

Both are set to take SS at age 70, but ESPlanner optimizes.

Inflation is set at 3%.
Nominal return on retirement assets: 6%
Nominal return on regular assets: 5%
State of Residence: New York

Implementation in ESPlanner

Run the basic profile.
Copy the basic profile and change as follows: Don’t enter the IRA under retirement accounts. Instead, treat the withdrawal from the traditional IRA, including accumulated income, as a 2010 taxable special receipt. Enter this same amount as a 2010 contribution to a Roth account.

Run this new profile; compare the living standard path generated with that from the basic profile.

The table below shows, for selected years and in today’s dollars, the couple’s annual living standard (discretionary spending, which we call consumption, adjusted for economies in shared living) and taxes. By converting to the Roth, the couple raises its living standard by 2.45 percent from $93,945 to $96,251 for each year of their life from age 59 through age 100.

The table also shows the gains from conversion if taxes are permanently increased by 30 percent starting in seven years when the couple reaches age 65. Now there is a 5.2% percent gain from converting.

What explains this gain? After all, conventional wisdom is that it deferring taxes is the tax-savvy thing to do. The explanation is that by bunching a good part of their taxable income into a single year, Tom and Janet are able to dramatically limit the taxation of their Social Security benefits as well as lower their marginal tax brackets in future years, particularly very late in life when they withdraw from their Roth accounts.

To be more precise, when they don't convert Tom and Janet land, late in life, in the 85 percent bracket with respect to paying taxes on their Social Security benefits; i.e., every extra dollar of adjusted gross income means that Tom and Janet will pay taxes not just on that extra dollar, but also an extra 85 cents of Social Security benefits. Stated differently, every dollar more (less)of adjusted gross income raises(lowers) Tom's and Janet's taxable income by $1.85.

Hence, there is a very big tax-saving bonus to Tom and Janet from reducing their adjusted gross income in old age. But this is precisely what happens when they convert to a Roth. The withdrawals from the Roth late in life are not included as part of their adjusted gross income. So in paying a lot more taxes in 2010, Tom and Janet get to pay a lot less in taxes late in life.

The reason that Social Security benefit taxation becomes so pernicious to Tom and Janet late in life is that the income (calculated basically as AGI plus half of Social Security benefit) thresholds beyond which first 50 percent and then 85 percent of their Social Security benefits become subject to taxation are not, themselves, indexed to inflation. These Social Security thresholds as well as the threshold beyond which households are subjected to the Alternative Minimum Tax are the most noticably unindexed features of the U.S. tax code.

In addition to reducing Social Security benefit taxation, converting to the Roth lowers the couple's federal income tax bracket late in life from 25 percent to 10 percent. Finally, the converstion moves the couple from the 85 percent to the 50 percent marginal Soical Security benefit taxation bracket.

It Pays to Convert!

There is some follow up discussion and a bit more detail on this case study in our forum. Click here to read it.