Cook Wealth Management Group

Why Isn’t Cook Wealth Promoting Roth Conversion?

Beginning in tax year 2010, the $100,000 modified adjusted gross income limit on conversions of traditional IRAs to Roth IRAs is no more. Now, just about anyone has the option to convert his or her IRA to a Roth IRA.

It may be popular, but it’s not always beneficial

Roth conversion seems to be the latest trend, and like many trends, years from now those who participate may ask themselves, “What was I thinking?” Magazines, blogs, radio, tv – the media tells us that Roth conversion is a great idea for everyone. And it may sound like one: paying income taxes based on the amount converted in 2010 – or paying over the course of 2011 and 2012* – and maybe paying no tax on the withdrawals after retirement.

Does it sound too good to be true? For a majority of IRA owners, the claimed advantages of Roth conversion will not occur for decades, if at all. And after October 15, 2011, the substantial upfront tax payment cannot be reversed.

What are the potential disadvantages of Roth conversion? Who could actually benefit and how long would it take to recover the costs of converting? To answer these questions, we’ve run a number of projections, not only out of curiosity, but concern for those who may be erroneously swayed.

The numbers tell all

While future tax laws cannot be predicted with any accuracy, that taxes will be due upon Roth conversion is certain, and the amount of taxes due can be estimated within a reasonable range. Based on our calculations, the table below shows the probable timelines to recover the upfront and carrying costs of Roth conversion – that is, paying conversion tax now in hopes of future tax savings.

Conversion Age 30 40 50 60
Years to Break Even 33 28 22 20

We ran projections for various age groups assuming investment pre-tax returns of 8% inside the IRA and after-tax returns of 4% outside the IRA.  We also assumed an overall tax rate of 33% on the amount converted and 25% on any future taxable withdrawals beginning at age 61. (Our projections are admittedly speculative, but given the uncertainty of tax law, they must be. These projections are reasonable based on our knowledge of current tax law and investments available in the marketplace.)

What does all this say about Roth conversion?

Breaking even takes too long

As shown above, the younger the account owner is at the time of conversion, the better the long-term advantage, which is consistent with popular pro-conversion rhetoric.  However, our research also indicates that it takes much longer to break even. Pre-paying taxes only becomes beneficial after breaking even, and the account owner or beneficiary cannot begin getting back the taxes paid upfront and the carrying costs until he or she makes the anticipated tax-free withdrawals, which typically occurs after age 59 ½.

Pre-paying taxes is impractical

What about the practicality of paying taxes upfront?  What single or married taxpayer in their 30’s or 40’s can afford to pay a hefty tax bill now, and wait several decades to get the money back, if at all? Many people in their 50’s or 60’s won’t have enough to retire comfortably in the first place;1 it certainly won’t help to pre-pay taxes.** Furthermore, writing checks to the IRS and state with no assurance of its benefits poses quite a risk – to one’s pocketbook and peace of mind.

Tax law could get in the way

What will happen with taxes in the future?  Flat tax, national sales tax, value-added tax – any of these could impact future tax projections and possibly eliminate the potential future savings of a Roth conversion now. Tax rates change often, and it is unwise to presume they won’t.

The exceptions are few

There are exceptional cases in which Roth conversion makes sense. Potential candidates for Roth conversion include those who:

  • have large ordinary losses/deductions
  • have very low or no income
  • won’t be able to absorb itemized deductions or exemptions

But those in these situations may benefit even more by cashing out their IRAs and paying a 10% early withdrawal penalty. It depends on the numbers.

It’s not for everyone

The media promotes the potential advantages of converting to a Roth IRA with little attention to the likely disadvantages. These promotions are exaggerated, misleading, and a general disservice to the public. Given the length of time it takes to recover the upfront costs, the impracticality of pre-paying taxes, and the uncertainty of tax law, Roth conversion is not favorable for most IRA owners.

Note: Young taxpayers who are eligible and can afford to make annual Roth contributions should consider doing so. Making Roth contributions can be a valuable way to build assets for future needs, such as retirement, a home down payment, or even education. What’s more: contributions (not earnings) can be withdrawn at any time with no tax consequences.

While our firm would recommend a client convert to a Roth IRA if he or she has a unique and fitting tax situation, we wouldn’t claim that Roth conversion is ideal for anyone without first examining that individual’s finances. We have reviewed our client list and identified account owners eligible for conversion; we will contact those who, in our opinion, might benefit from converting to a Roth IRA. If you have any questions, or would like to discuss your individual situation, please contact us.

*Tax rates may increase in future years, making conversion even less beneficial.
**State tax varies widely and should be factored in to the projected cost of converting as well.
1 Study performed by the Employee Benefit Research Institute and published in Issue Brief: The EBRI Retirement Readiness Rating:™ Retirement Income Preparation and Future Prospects #344 by Jack VanDerhei and Craig Copeland of EBRI. July 2010.