Proving an IRA Conversion to Roth IRA is a good idea.
Assume: Amount to convert, $160,000 early in 2010.
Age 64 December of 2009.
Federal tax 35%, State tax 8% or $68,800 total tax paid.
Full tax paid 4/15/2011 with Non Qualified Funds.
Growth of IRA and Roth IRA 5%, no contributions.
I have developed excel spread sheets to compare not converting, against converting and am looking for confirmation that my calculations and conclusions are correct. I’m not an accountant so your input would be greatly appreciated.
First I developed a (Status Quo) spread sheet for a $160,000 IRA growing at 5% and taking Required Minimum Distributions (RMDs) at 71 years old. Taxes were paid on the RMDs at 35% and After Tax Distributions were calculated for each distribution year beginning in 2010 and ending in 2040. It literally depicts the IRA value each year.
Because Non Qualified funds were used to pay taxes on the conversion, next I developed a (FVM Future Value of Money Adjustment) spread sheet for the $68,800 in taxes paid, growing at 5% and paying taxes at 35% each year starting in 2011.
The final spread sheet, first calculates a Roth IRA future value for 2010 thru 2040 with no withdrawals. This I call (Roth IRA Value NO Adjustment). Next I adjust this value for After Tax RMDs that would have been made if there was no conversion. Additionally I adjust it using the FVM Adjustment calculated above which gives me a Roth IRA Adjusted Value. Next I take the Status Quo IRA Value for each year and calculate a Status Quo After Tax IRA Value as if there was no conversion and compare it each year to the Roth IRA Adjusted Value.
Conclusions:
After just 6 years the Roth IRA Adjusted Value is greater than the Status Quo After Tax IRA Value. Conclusion: This is the break even point with a 35% tax rate.
Re-making the spread sheets using a 45% tax rate the Roth IRA Adjusted Value is greater than the Status Quo After Tax IRA Value immediately.
If tax rates increase in future and I believe they will, the advantage for converting to a Roth IRA will only increase from my calculations. None of this takes into account additional advantages if the Roth IRA is now willed to the children instead of the IRA.
I can send the excel files to anyone that is interested. I can be reached at [email protected]. Please let me know your thoughts on or off forum.
Permalink Submitted by Anonymous (not verified) on Fri, 2009-09-25 17:47
I just ran your numbers, as close as possible, on Vanguard’s online calculator: “Should I Convert to a Roth IRA” and it appears the result seems to prove your point.
https://personal.vanguard.com/us/planningeducation/general/PEdGPPlnTools…
For me the conversion concept has always had another component in it. [u]Peace of Mind[/u] that in 5 years or 59 1/2 (whichever comes first) the conversion amount is available without owing any tax or penalty.
pmk
Permalink Submitted by Steve Glasgow on Fri, 2009-09-25 21:12
Thanks PMK. Vanguard’s online calculator does seem to support my conclusion. The problem is it does not take into account state taxes due, will not let me raise the tax rate above 35%, and it is not set up for the special rules in 2010.
I agree with your peace of mind statement 100%. Also there is the tax free advantage when it is willed to the kids.
I can send the excel files to you or anyone that is interested. I can be reached at [email protected].
Steve Glasgow
Permalink Submitted by Steve Glasgow on Sun, 2009-09-27 20:07
Come on guys and dolls. Help me out with some comments.
Steve Glasgow
Permalink Submitted by george collins on Tue, 2009-10-13 21:45
At retirement, The RMD also increases the %of SS that will be taxed as it increases total taxable income. Keeping the taxable income below 70K$/yr (not including SS) reduces the amount of SS that is taxed. By deferring my SS to 70 yrs old, and converting my IRA, this 🙂 provides income reduction and a compounding reduction in taxes. This tax reduction allows me to withdraw from the Roth than the RMD a year to maintain the same income(130k/yr)
jc
Permalink Submitted by Joseph Arsenault on Thu, 2009-10-15 22:56
Steve,
Any time you have the ability to pay the taxes from outside the account you are moving assets from a taxable environment into a tax free enviroment. Someone already stated the affect on social security, which is a very valid point. For the most part if your just going to be mathematical about it, you want to look at the current tax rate upon conversion vs the the rates upon distribution, do they go down or up (it seems like you have done this)? Then you look at the ability to pay the taxes inside or outside the account. Sometimes its like PMK stated.. Piece of mind, No RMDs, tax free to heirs so more stretch power, hedging against potentially inflated tax rates for years to come, etc… If your trying to convince someone, the net benefit may be marginal compared to the flexibility and security it may create for them.
-J
Permalink Submitted by Steve Glasgow on Thu, 2009-10-15 23:04
Hi J,
I agree totally. One size does not fit all. Steve
Permalink Submitted by george collins on Wed, 2009-12-02 13:37
I plan on converting most of my IRA in January. Have sufficient income. Will start SS at 70. I do not want any RMD’s. Roths will be willed to children(after wife’s refusal). ❓ Since I have medical insurance, is there any reason I should keep some of My IRA???
Permalink Submitted by Joseph Arsenault on Wed, 2009-12-02 14:34
Just an FYI
Dont “will” your IRA to your children, just make sure they the beneficiaries on the custodians beneficiary form. This will avoid probate entirely and be more seamless for your beneficiaries.
As far as your other question, there is not enough information for me to help, maybe someone else can.