Convert Your IRA to a Roth!

Since 2010 everyone, regardless of income, is eligible to convert qualified retirement savings into a ROTH IRA. 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. We will see below that the value of the conversion can depend on where you live but also, even more significantly, when you intend to take Social Security.

Basic Profile

Current year is 2014
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

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 Traditional 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 their Social Security benefit at age 70. ESPlanner indicates that Tom can file and suspend and trigger a spousal benefit for Janet at her full retirement age until she moves to her own benefit at age 70.

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
Current year for this study is 2014
Run the basic profile to establish the baseline.

Copy the basic profile and change as follows:
1. Indicate a $300,000 contribution to the ROTH in 2015
2. Indicate a $300,000 withdrawal from individual account in 2015.
3. Run this new profile; compare the living standard path generated with that from the basic profile.

In every case below, the ROTH balances are withdrawn toward the end of life, only after all other qualified assets have been withdrawn.

ESPlanner will calculate the tax consequences of this conversion, but it will not impose the 10% penalty that you would create if you did not complete the conversion properly.

Table 1 below shows, for selected years and in today’s dollars, the couple’s annual discretionary spending before (left) and after (right) the conversion. By converting to the Roth, the couple raises its living standard by $2,584 (2.49%) from $103,831 to $106,415 for each year of their life from age 58 through age 100.

Table 2 also shows the gains from conversion if taxes are permanently increased by 30 percent starting when the couple reaches age 65. Now there is a 4.32% percent gain from converting (i.e., $4,335 annually through age 100).

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 noticeably 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 conversion moves the couple from the 85 percent to the 50 percent marginal Social Security benefit taxation bracket.

Before leaving this case study, it's worth noting that results vary depending on the context.

We'll use the same data (but not the 30% tax hike) and describe what happens to Table 1 if the couple lives in Michigan instead of New York. With no ROTH conversion, discretionary spending is at $106,309 compared to the ROTH conversion of $108,200. That's an annual difference of $1,891 or 1.78% (compared to 2.49%) because of the difference in state taxes.

And, back to living in New York, if we spread the $300K conversion across three years to disperse the tax burden a bit, we see a discretionary spending when there is no conversion and $103,831 become $106,174 ($2,343 annually or 2.26%) with the conversion. That's not much difference from the 2.49% same case where the $300,000 is converted all in one year.

Finally, note what happens if the couple does not defer their Social Security to age 70 but instead takes it at their full retirement age. In this case, before converting they have a discretionary spending of $98,705, and after the $300K ROTH conversion, the discretionary spending rises to $100,297 ($1,592 annually or 1.61%). Compare that to the data in Table 1 where the couple postpones Social Security to age 70 and sees a $2,584 (2.49%) annual increase in discretionary spending. This example indicates that the impact of a ROTH conversion has a lot to do with when you plan to take Social Security.

Table 3 compares taxes in the final years when the ROTH (in the bottom table) is available to withdraw because of the conversion.

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