Key Points
– The primary factor in a Roth IRA conversion decision is the difference between the tax rate at conversion and the future tax rate at distribution.
– Tax-free growth in a Roth IRA is a significant benefit, but its impact is tied to how it affects future tax rates.
– Distributions from a Roth IRA do not affect your Adjusted Gross Income (AGI), which can prevent other costs like increased Medicare premiums.
– Other factors like Required Minimum Distributions, state taxes, and where the conversion tax is paid from can also influence the decision.
Q. Dan, I see a lot of things about Roth conversions with most of the attention on tax rates. However, once funds are in the Roth account, any returns on investing that money are also tax free. That seems to me to be a major factor in the decision as well. Why the obsession with tax rates? — P in Palm Bay
A. P, the difference in the tax rate applicable at the time of conversion and the rate applicable on a future distribution is the top issue. The growth matters but it matters only to the extent it affects the future tax rate. An example should help.
Say we convert $10,000 at a 20% tax rate and grow the account by 4 times. So, $10,000 less 20% equals $8,000 in the Roth IRA. Grow that by a factor of 4 and there is $32,000 in the Roth IRA. If we had not converted, the IRA would be worth $40,000.
If the rate applicable upon distribution stays the same at 20%, the conversion had no effect. You either converted and received a $32,000 tax-free distribution from the Roth IRA or took a $40,000 distribution from the traditional IRA less 20% ($8,000) also netting $32,000.
If the rate applicable upon distribution is lower than 20%, say 10%, instead of receiving $32,000 tax-free from the Roth IRA, your net after taxes from the traditional IRA would be $40,000 less 10% ($4,000) or $36,000. The conversion cost you $4,000, wholly attributable to the difference in tax rates.
If the rate applicable upon distribution is higher than 20%, say 30%, instead of receiving $32,000 tax-free from the Roth IRA, your net after taxes from the IRA would be $40,000 less 30% ($12,000) or $28,000. The conversion saved you $4,000. Again, the difference is wholly attributable to the difference in tax rates.
Distributions from Roth IRA don’t affect AGI
If we change the growth rate, the results will be the same; if the tax rate upon future distribution is higher, the conversion pays. Otherwise, it does not. Note too, that how long it took for the 4X growth to occur is immaterial to this math. It doesn’t matter if it took one day or 30 years to go 4X.
Obviously, the more time, the bigger the potential growth, the bigger the potential withdrawal and the higher the potential rate. However, it isn’t strictly the size of the withdrawals, it’s the rate that is applied to the distribution that matters.
As with so many aspects of the tax code, it isn’t so simple. If you pay the $2,000 in taxes upon conversion in our example from a non-retirement account, there will be $2,000 less in the account from which you paid taxes but $10,000 in the Roth IRA not $8,000 available to grow tax-free. Further, the example assumes that both the IRA and Roth IRA grow at the same rate but in practice, there are often differences. Also, moving to or from a high tax state between the conversion and distribution can make a difference.
Distributions from the Roth IRA are not only tax-free, they do not affect Adjusted Gross Income (AGI). Both the amount converted to a Roth IRA and the distribution from the traditional IRA is included in AGI. A higher AGI can trigger other taxes or costs like an increase in Medicare premiums.
You also have to account for Required Minimum Distributions both for you and for your heirs. New rules on inheriting IRAs and Roth accounts complicate the matter of estimating future tax rates.
Bottom line: Growth can have a great influence on the conversion decision, but the applicable tax rates upon conversion and upon distribution remain the most important consideration.
If you have a question for Dan, pleaseemail him with “MarketWatch Q&A” on the subject line.
Dan Moisand is a fee-only financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.
Originally published on FloridaToday. Read the original article here.