It seems like a simple calculation. You make your best guess about your tax bracket in retirement. If it will rise, converting a traditional IRA into a Roth could be a good move. If it will fall, a conversion probably won’t pay.
But there’s another wrinkle in the conversion decision, which millions of investors are weighing now that the $100,000 income limit has been scrapped. The second critical question is: Where will you get the money to pay the conversion tax?
As most investors now know, a Roth can be better than a traditional IRA, or TIRA, because withdrawals in retirement will be tax-free, while money taken from a TIRA is taxed as income. But if you switch your money from a TIRA to a Roth, you have to pay income tax right away. So you face a tax bill either way. It’s a question of pay now or pay later, and it generally makes sense to pay tax when your bracket is lower rather than higher.
But how, exactly, should you pay the tax. The first instinct is to pay it out of the converted funds. If you’re in a 25% tax bracket and convert $10,000, you’d pay $2,500 in taxes.
Obviously, that leaves you with only $7,500 to put into the Roth. It will grow tax-free, but can it grow enough to overcome this initial setback?
That would depend, of course, on a lot of factors like investment returns and the number of years before withdrawals begin. But most experts warn that paying tax out of the converted funds is a crippling blow that makes the conversion a money loser in most cases.
The Roth IRA Conversion Calculator takes this into account. In the default example, the three bars show how a 28-year-old investor with a $10,000 TIRA might fare with three strategies. Currently, the investor is subject to a 25% income-tax rate and a 15% rate on investments, the long-term capital gains rate. The investor assumes he will have a 15% income tax rate in retirement.
At first glance, the conversion seems to make lots of sense. After the conversion, the Roth would grow to $172,000 by the time the investor reached 65, while the TIRA would grow to about $147,000.