Tax Brackets Key to Roth Conversions

Deciding whether to convert a traditional IRA into a Roth is a tricky decision involving a little math and a lot of guesswork. Many people are wrestling with the problem this spring, as new rules allow anyone to convert to a Roth, not just those earning less than $100,000 a year.

The Roth allows tax-free withdrawals in retirement, while you must pay income tax on withdrawals from traditional IRAs, or TIRAs. But income tax is levied on sums converted from TIRAs to Roths. So, the question is whether to pay tax now or later.

Many factors affect the math — the expected rate of return on investments, inflation, the number of years to retirement and so forth. But one is clearly the most important — how your tax bracket may change over time.

If you know the numbers, the Roth IRA Conversion Calculator can make the pros and cons of a conversion very clear. Unfortunately, no one can predict future tax brackets with any certainty, as that will be determined by your income and tax laws (which have a habit of changing dramatically from decade to decade).

Let’s start with a simple example using the calculator’s default figures. A 28-year-old planning to retire at 65 has $10,000 in a TIRA and expects returns to average 8% a year. In the bar graph, the key is to compare the nest egg that could be built up in the Roth with one you could have by keeping the TIRA and also investing the money you would save by avoiding a conversion tax. (A full explanation of that will come in the next column.)

The graph shows that keeping the traditional IRA makes the most sense. That strategy will produce $175,000, while converting to a Roth will produce $172,000.

This assumes the investor is in a 25% income-tax bracket now but will face a 15% bracket in retirement.

What if you reverse those figures, assuming a 15% bracket now and 25% in retirement? Then the Roth conversion would clearly make sense, producing $172,000 versus $146,000 with the traditional-plus-taxable strategy.

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