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Converting a traditional IRA to a Roth IRA: 3 case studies

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The following three case studies assume you convert a traditional deductible IRA or SEP account that's currently worth $50,000 into a tax-free Roth IRA account. (Note: The projected results are based on average assumptions [future tax rates, rates of return, etc.]. Your tax pro can put together more detailed estimates based on your circumstances and assumptions.)

Case 1: Tax rate at retirement same as now

Assumptions: 9 percent pretax rate of return on account balance between now and retirement in 20 years; 33 percent tax rate on income triggered by Roth conversion; 33 percent tax rate if traditional IRA is liquidated after 20 years; 7 percent after-tax return on cash used to pay Roth conversion tax hit (money that could have otherwise been invested in a taxable brokerage firm account until retirement).

Future value of tax-free Roth IRA: $280,220

Future value of $16,500 conversion tax: ($63,850)

Net future value of Roth alternative: $216,370

Future value of traditional IRA after taxes (assuming no Roth conversion): $187,750

Conclusion: Converting to Roth IRA puts you ahead by: $28,620

Case 2: Slightly lower tax rate at retirement

Assumptions: Same as Case 1, except now assume a 28 percent retirement-age tax rate (instead of 33 percent) if traditional IRA is liquidated in 20 years.

Future value of tax-free Roth IRA: $280,220

Future value of $16,500 conversion tax: ($63,850)

Net future value of Roth alternative: $216,370

Future value of traditional IRA after taxes (assuming no Roth conversion): $201,760

Conclusion: Converting to Roth IRA puts you ahead by: $14,610

Observation: Comparing Case 1 and 2, you'll see that converting to a Roth IRA works best when your retirement-age tax rate remains the same or higher than your current rate on income triggered by the Roth conversion.

Case 3: Only 10 years until retirement


Assumptions:
Same as Case 1, (including 33 percent tax rate), except now assume you have only 10 years until your expected retirement age, as opposed to 20 years.


Future value of tax-free Roth IRA: $118,370


Future value of $16,500 conversion tax: ($32,460)

Net future value of Roth alternative: $85,910


Future value of traditional IRA after taxes (assuming no Roth conversion): $79,310


Conclusion: Converting to Roth puts you ahead by: $6,600


Observation: Converting with 10 years to go until retirement still puts you ahead of where you'd be with a traditional IRA, but not by as much as when you have more years until retirement. Conversion works best with many years available to earn tax-free Roth IRA income and gains to compensate for the upfront conversion tax hit.

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