By Carl A. Brooks, CFP
© 1998, North Carolina Bar Association
From "The Will and the Way"
February 1998, Vol. 17, No. 2
(This article is available on the World Wide Web exclusively at the Roth IRA Web Site)
The basic question: Does it make sense to pay taxes now in order to avoid taxes in the future? Your basic answer: It depends on several key assumptions. However, we can analyze the Roth IRA conversion and isolate the key issues. After reading this, you will have a better understanding of the dynamics involved and be able to offer guidance to your client. Each case must be evaluated individually.
If you examine the problem in its simplest form, you realize that there is no advantage to pay taxes now versus later.
Tom is 60 years old and has a $100,000 IRA which grows at 10 percent. His 35-percent income tax bracket is constant, in 10 years all money is withdrawn and taxes are paid. Both options will end with the same result.
| Regular | Roth | |
| $100,000 | 35% tax> | $65,000 |
| @10% | 10 years | @10% |
| $259,370 | $168,591 | |
| -$90,779 | <35% tax | |
| $168,591 |
Of course, in the real world there are a multitude of variables which will affect the outcome of the analysis: Roth conversion rules, size of the IRA, age of owner, tax rates, growth rates, availability of non-IRA assets to pay taxes, age at death and actions of the beneficiaries. To understand the dynamics of this decision given the constraints of the article, we will isolate a few variables that can have a major impact on the outcome.
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Example 1
The Value of Spreading Taxes Over Four Years and No RMD
Tom (age 60) $100,000 IRA earns 10 percent. 35 percent marginal bracket.
Values are net of all taxes if withdrawn plus the required minimum distributions
reinvested at 10 percent.
Roth conversion taxes are paid from the Roth IRA, but without 10 percent penalty.
Comparison Net of Tax
| Age | Regular IRA | Roth IRA | Difference |
| 60 | $71,500 | $75,000 | 4.90% |
| 62 | $86,515 | $95,388 | 10.26% |
| 64 | $104,683 | $116,382 | 11.18% |
| 66 | $126,667 | $140,822 | 11.17% |
| 68 | $153,267 | $170,394 | 11.17% |
| 70 | $185,396 | $206,176 | 11.21% |
| 72 | $223,807 | $249,673 | 11.47% |
| 74 | $269,324 | $301,862 | 12.08% |
| 76 | $322,891 | $365,253 | 13.12% |
| 78 | $385,562 | $441,956 | 14.63% |
| 80 | $458,481 | $534,767 | 16.64% |
| 82 | $542,886 | $647,068 | 19.19% |
| 84 | $640,178 | $782,953 | 22.30% |
| 86 | $752,421 | $947,373 | 25.91% |
| 88 | $881,949 | $1,146,321 | 29.98% |
Example 1: The initial benefit of the Roth comes in the value of spreading the conversion income tax liability over four years. Keeping all other factors constant, this factor alone will provide a significant advantage and is why conversion in 1998 is so important. Note that the difference does not change between age 64 and age 70.
A second advantage of the Roth is no required minimum distibution at age 70½. When Tom reaches age 70, the Roth begins to enjoy an ever-increasing advantage because of the additional deferral (example assumes that the net after-tax required minimum distributions are invested at 10 percent). Keep in mind that individuals withdrawing more than the minimum from their IRAs would find no benefit in this factor.
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Example 2
What Happens if Tax Rates are Lower Down the Road
Tom (age 60) $100,000 IRA earns 10 percent. 35 percent marginal bracket
now, 15 percent after age 65.
Values are net of all taxes if withdrawn plus the required minimum distributions
reinvested at 10 percent.
Roth conversion taxes are paid from the Roth IRA, but without 10 percent penalty.
Comparison Net of Tax
| Age | Regular IRA | Roth IRA | Difference |
| 60 | $71,500 | $75,000 | 4.90% |
| 62 | $86,515 | $95,388 | 10.26% |
| 64 | $104,683 | $116,382 | 11.18% |
| 66 | $165,641 | $140,822 | -14.98% |
| 68 | $200,426 | $170,394 | -14.98% |
| 70 | $242,484 | $206,176 | -14.97% |
| 72 | $293,113 | $249,673 | -14.89% |
| 74 | $353,829 | $301,862 | -14.69% |
| 76 | $426,434 | $365,253 | -14.35% |
| 78 | $513,042 | $441,956 | -13.86% |
| 80 | $616,125 | $534,767 | -13.20% |
| 82 | $738,570 | $647,068 | -12.39% |
| 84 | $883,789 | $782,953 | -11.41% |
| 86 | $1,056,080 | $947,373 | -10.29% |
| 88 | $1,260,510 | $1,146,321 | -9.06% |
Example 2: So far conversion looks great, however the variable with the biggest impact is marginal tax rates. What happens if Tom and Martha retire and move to Florida where there is no state income tax, or if one of the flat tax proposals at a lower rate finds popular support? In this example, we assume Tom’s marginal tax rate drops to 15 percent and the results would suggest that conversion would be a mistake.
There is an advantage to using assets available outside of the IRA to pay the income tax liability resulting from the conversion.
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Example 3
The Value of Using Outside Assets To Pay Income Taxes
Tom (age 60) $100,000 IRA and $40,000 other assets growing at 10 percent.
35 percent marginal bracket.
Values are net of all taxes if withdrawn plus the required minimum distributions
reinvested at 10 percent.
Roth conversion taxes are paid from the Roth IRA, but without 10 percent penalty.
Comparison Net of Tax
| Age | Regular IRA | Roth IRA | Difference | Roth IRA (Taxes in) |
Difference |
| 60 | $115,220 | $118,720 | 3.04% | $117,845 | 2.28% |
| 62 | $138,076 | $147,193 | 6.60% | $144,078 | 4.53% |
| 64 | $164,846 | $177,771 | 7.84% | $172,201 | 4.46% |
| 66 | $196,441 | $213,831 | 8.85% | $205,516 | 4.62% |
| 68 | $233,907 | $257,418 | 10.05% | $245,133 | 4.80% |
| 70 | $278,405 | $310,059 | 11.37% | $292,360 | 5.01% |
| 72 | $330,945 | $373,606 | 12.89% | $348,747 | 5.38% |
| 74 | $392,634 | $450,308 | 14.69% | $416,133 | 5.99% |
| 76 | $464,732 | $542,886 | 16.82% | $496,760 | 6.89% |
| 78 | $548,651 | $654,626 | 19.32% | $593,253 | 8.13% |
| 80 | $645,940 | $789,504 | 22.23% | $708,810 | 9.73% |
| 82 | $758,293 | $952,327 | 25.59% | $847,263 | 11.73% |
| 84 | $887,640 | $1,148,903 | 29.43% | $1,013,320 | 14.15% |
| 86 | $1,036,693 | $1,385,849 | 33.68% | $1,211,932 | 16.90% |
| 88 | $1,208,768 | $1,668,645 | 38.05% | $1,447,898 | 19.78% |
Example 3: Assume that Tom has an additional $40,000 (invested exactly the same way as his IRA) which could be used to pay the income taxes. The percentage difference is lower because the total amount of assets ($200,000) has doubled. However, notice the significant advantage of paying the tax liability from outside assets. Should the technical corrections bill pass in its present form, the difference will be even more dramatic.
When reviewing Roth conversion illustrations, the 20-, 30- or even 40-year results can be impressive. However, our confidence in the assumptions diminishes as the time frame of the analysis grows. Twenty years ago, the top marginal rate was 77 percent! At best we are making assumptions based upon a logical approach to probability to predict an uncertain outcome.
In the foreseeable future, the client’s tax rate at withdrawal is one of the most important variables. Therefore, it would seem prudent to consider conversion of some part of the traditional IRA if for no other reason than to hedge potential income tax changes. Clients nearing the required beginning date who do not need the income are the best candidates, especially if they have non-IRA assets with which to pay the tax.
There are many other factors that can play a major role in the final decision. Only a comprehensive evaluation of each client’s situation will provide a viable analysis.
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Brooks is an executive vice president of Carroll Financial
Associates, Inc.,
a financial planning and portfolio management firm based in Charlotte.
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The preceding article has been reprinted with permission from The Will & the Way, Vol. 17, No. 2 (February 1998), a publication of the North Carolina Bar Association's Estate Planning & Fiduciary Law Section. Copyright 1998 N.C. Bar Association.