Beware the Roth conversion trap

The Feds have set a nasty but subtle trap for high income IRA investors and if you aren't careful, it could end up costing you hundreds of thousands of dollars.

In 2006, President George W. Bush signed the Tax Increase Prevention and Reconciliation Act. Among other things, this law liberalizes the rules for converting traditional IRA's into Roth IRA's in 2010. In the past, such conversions were subject to strict income limits but, as of January 1, those limits were eliminated. To further sweeten the deal, IRA holders who convert now have two years to pay the taxes associated with conversion instead of the previous one year. 

The problem with these more liberal rules is that converting from a traditional IRA to a Roth IRA is a seriously bad idea for most people. The following example will help illustrate what I mean.

Let's suppose I'm an investor with 20 years to retirement. Suppose further that my traditional IRA is currently worth $100,000 and my investments generate a 10 percent annual return. By the time I retire 20 years from now my IRA will be worth almost $673,000.  

If I choose to convert to a Roth this year, I will have to pay federal and state taxes on the converted amount thereby reducing my Roth balance to about $65,ooo. If I invest my Roth in the same portfolio earning a 10 percent annual return, it will grow to slighly more than $437,000 in 20 years.

No surprises here. Both balances have grown by the same percentage rate and the Roth is still equal to the traditional IRA adjusted for the impact of the taxes we paid at conversion. However, the fact that the Roth balance is so much less makes a very big difference as I move into the distribution phase of my IRA.

If I am in good health when I retire at age 65, the actuaries tell us that I have a 1 in 4 chance to live to be at least 95 years old. That fact has two important implications. First, I need to invest my portfolio for a fairly long time horizon. Second, I need to make sure my money lasts so I don't want to take out too much money every year. Nobody wants to run out of money in their old age.

With these implications in mind, let's suppose I invest my traditional IRA during retirement so that it continues to generate a 10 percent annual return and that I withdraw 5 percent each year to help support my retirement lifestyle. Because the return on my portfolio exceeds my distribution rate, the portfolio value continues to grow (in this case at a 5 percent rate) helping me keep up with inflation.

As the balance grows, so do my annual distributions. But remember that I pay taxes on distributions from a traditional IRA as if they are ordinary income, so the actual money I receive is quite a bit less than the gross distribution.

With these principles in mind, we can now develop a standard by which we can determine whether it makes sense for me to convert my traditional IRA to a Roth IRA. 

If a Roth conversion cannot deliver a stream of distributions at least as big as the after-tax stream produced by my traditional IRA, AND, if the ending balance on the converted IRA is not at least as big as the ending balance for the traditional IRA, then the conversion is a bad idea.

I can test any potential Roth conversion against this standard by following a few basic steps. If this seems complicated, don't worry--I've attached a spreadsheet to help you with this.

  1. Project the balance of the IRA at retirement as a traditional IRA and if it were converted to a Roth.
  2. Project the annual after-tax distributions the traditional IRA would produce and the value of the traditional IRA in each year of retirement.
  3. Project the value of the converted IRA each year if distributions were taken equal to the after-tax distributions from the traditional IRA.
  4. The difference between the two ending balances is the amount of wealth created or destroyed by the conversion. If the ending balance for the Roth exceeds that of the traditional IRA, the conversion makes sense. However, if the ending balance for the Roth is less than the traditional IRA, the conversion is a trap.

In my example, converting to a Roth destroys significant amounts of wealth and the amount of wealth destroyed grows larger the longer my retirement lasts. These results hold under most conditions I tested. There are a few circumstance in which conversion may result in wealth creation. These include:

  •  When tax rates in retirement are significantly higher than during pre-retirement years.
  • When the account balance suffers a dramatic short-term reduction and then experiences a dramatic recovery.
  • When income (and therefore the marginal tax rarte) is artificially depressed for a brief period of time and the reverts to a higher level and stays there.

I recognize that many readers may be surprised by how bad a Roth conversion looks when cast in this light. Most of the people I come across tend to think of Roth conversions as a way to save on future taxes. While a Roth conversion will definitely reduce future taxes, any decision about converting to a Roth must be considered in the context of what it will do to your overall wealth.

The bottom line? Do the numbers before you do the conversion.