Start IRA Conversions Early To Have More Purchasing Power Later

by: Doctor Dividend

I recently made a comment on David Crosetti's article, found here about doing a Roth IRA conversion as the author nears retirement. Another excellent contributor, Robert Allan Schwartz, asked if I could expand on the concept as he begins to approach retirement. The good news for Robert is he doesn't have to wait until then to start doing the conversion, but I don't want to jump the gun and explain the concept of what is a Roth IRA conversion and when and why it should be done with some key concepts in mind.

What is a Roth IRA Conversion?

It is not new news that the government's fiscal responsibility is beyond abysmal and wants access to the trillions of dollars in the contribution plans of 401(k)s, traditional IRAs, and SEP-IRAs (I will clump these all together as just IRAs for the remainder of the article). To get the tax dollars now, the government started in 2010 to allow any person to begin converting pre-tax dollars in an IRA into future tax-free dollars of a Roth IRA by paying the tax in the year you convert the money from an IRA to a Roth IRA. The amount of money you decide to convert will be taxed as ordinary income even though you will be transferring from one qualified retirement plan to another retirement plan, never personally touching your hands in the process.

You may be thinking why would I want to do this? I will have less total dollars for retirement!! As James Lange describes in his book, "Roth Revolution," (free ebook found here) it is not about the total dollars one has, but the purchasing power of those dollars. If I have $100 of after-tax money in my pocket, I would need $125 pre-tax money for equal purchasing power. The second important point is we know what the tax rates are now. With the deficit growing at an exponential rate, it is hard to imagine a future where the tax rates will be going down. By doing the conversion now, you have "locked-in" your taxes (I am also going with the assumption that the Roth IRA in its current state will be grandfathered moving forward) and are moving towards a tax-free retirement. The final important reason is the required minimum distribution, or the RMD, that is REQUIRED from an IRA once you reach 70.5 years of age. You have been delaying for years, possibly decades, on paying taxes and the government is ready and waiting for their cut. By you choosing years before to start converting some money into a Roth IRA and paying taxes along the way, you are electing to minimize the tax-deferred balance and hence, minimize the distribution you MUST take to a withdrawal you ELECT to take, if needed. The corollary benefit that will occur is you also minimize the chance of having your Social Security benefits taxed, at least for those that expect to still get Social Security. For those that want a quick version of what the ebook is telling you, go here.

When should we do a Conversion?

It would be highly recommended to do a conversion in a year you became unemployed and/or your income dropped due to retirement or your job is commission based and it was just a down year. Why? Your effective tax rate will be lower than what you have known in years past. You are CONDITIONED to a certain tax bracket and that is the KEY to doing the conversion. You don't want to convert that it will make you go into a higher tax bracket than you are already accustomed to. If it can be done at a time where your tax bracket will be less that year for the reasons mentioned above, even better. Let's use some numbers to solidify the idea.

Here are our assumptions:

-The Roth IRA will be grandfathered along with the tax-free withdrawal of that money

-The 2013 tax rates will remain the same moving forward

-Couple Married Filing Jointly, ages 59, had net taxable income in 2012 of $80,000 (Taxable income of $12,060), which is the 25% tax bracket

-They have the one IRA with a value of $300,000

-They have one Roth IRA with a value of $50,000

-For simplification purposes, there is zero growth in the value of either IRA over the next ten years and removing inflation from the discussion

-In 2013, the couple semi-retires at the ages of 60 and will now have a net taxable income of $60,000 for the next 10 years until the ages of 70.

Because the couple's net taxable income has gone down, the tax rate has dropped them from the 25% bracket to the 15% tax bracket. On $60,000, the federal income tax owed will be $8,108 (as supplied by this website here). The 15% tax bracket upper limit is at $72,500, so our couple has a chance to convert up to $12,500 each year for the next ten years and remain in the 15% tax bracket. This will increase their taxes due from $8,108 to $9,983, or an increase of $1,875 but that $12,500 being converted now has a chance to grow and be distributed tax-free. Also understand that $1,875 is paid from money that is NOT being converted but from already taxed funds. After 10 years, the IRA value has gone from $300,000 down to $175,000. More importantly, your RMD at 70.5 years of age has dropped from $10,948.91 to $6,386.86 keeping your effective tax rate low, and this RMD is for the first year, with the percentage increasing over time. The Roth IRA value has grown from $50,000 to $175,000 and more importantly, has no requirement to be withdrawn while you are still alive. You choose to withdraw the money from the Roth IRA if you need to, not because the government says you have to. And it can continue to compound for many decades if the beneficiary is very young, leaving an impressive family legacy,


I know I oversimplified our example by taking out a lot of variables, but I think it is more important to understand the basic concept of the Roth IRA Conversion than start complicating things with growth of the IRA balances and other "What if?" scenarios because we all hope that our money, not just our dividends, but the actual value of the portfolio, does grow over time. But my take away points if you are to convert are the following:

1) You do not need to wait until you are 59.5 years of age to do a Roth IRA Conversion, especially if your income does go down drastically in one year, lowering your tax bracket

2) The taxes due for the Conversion are not to be paid from the actual money converted but must come from a different source

3) Provided you have the money for the taxes due, I would personally convert up to the upper limit of your new, lower tax bracket.

4) If you are young, change companies and remain in the same tax bracket, I would personally take your old company's 401(k), do a self-directed Rollover IRA, and then start doing the Roth IRA Conversion provided you can pay the taxes to do so.

5) And my final point, think in terms of purchasing power. I fully believe you are much better off paying the taxes now and funding a Roth IRA first, if you can. If your employer gives you the option of doing a Roth 401(k), DO IT!!! That is like a Roth IRA with the ability to stuff nearly three times more money into it than a true Roth IRA. If your employer will only match funds on the traditional 401(k), I would fund up to the match and stuff the rest you are legally allowed to into the Roth 401(k). Yes, you pay the taxes now, but I would rather pay the taxes once and let my money potentially compound tax-free for 50-70 years than save a few dollars on taxes now and pay a lot more for that benefit later.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am a healthcare practitioner who enjoys personal finance. The opinions I gave are mine and mine only. If you need further help understanding the concepts explained in this article, please find a financial professional that can help you personally.