Don’t let them talk you out of a Roth conversion

Dana Anspach for Market Watch writes: Imagine there was this fantastic financial tool that could save you money in taxes, and leave your surviving spouse in a more secure situation later in retirement, but everyone told you this tool was only for young people — so you ignored it.

Or maybe, just maybe, someone evaluated the use of it for you, but they said based on your expected marginal tax rate now and in retirement, it probably wouldn’t be of great benefit to you.

Now, suppose they were dead wrong.

What is this tool? It’s the Roth IRA and it is being grossly underutilized.

With a Roth IRA you put money in after tax (sorry, no deduction on your tax return) and it grows tax-free. You have the option to convert existing traditional IRA or 401(k) assets to a Roth, pay taxes during the year of the conversion, and from that point on it grows tax-free.

There are plenty of online calculators that you can use to evaluate the benefits of a Roth conversion but they are all missing the most important aspects of this amazing financial tool, and frankly, I’m getting frustrated about it.

Here are five things that are missing from the traditional IRA versus Roth analysis.

1. Social Security taxation

There is a complex formula that determines the portion of your Social Security benefits that are subject to taxation. Roth distributions don't count in this formula. Traditional IRA distributions do. This is important because once you reach age 70 1/2 you are required to take distributions from a traditional IRA, but not from a Roth. I explain the compounding effect of this in the next section.

2. Required minimum distributions (RMD)

Each year past age 70 1/2, you are required to withdraw a higher proportion of your traditional IRA. This withdrawal is taxable income. It flows into the formula that determines how much of your Social Security is subject to taxation. In your 70s, if you haven't planned for this, you may find yourself paying a much heftier tax bill than you anticipated. Each dollar you contribute to deductible plans today increases your potential RMD later — which means it increases your deferred tax liability. Shifting money to a Roth, either through contributions or conversions, can lead to an improved outcome as measured in terms of sustainable retirement income, taxes paid in retirement and expected assets to leave to the next generation.

3. Filing status change upon loss of a spouse

In retirement, the odds are about 21% that both of you live to 84 and about 72% that one or the other of you does. The odds of becoming a sole surviving spouse for several years are high. When you lose a spouse, your tax filing status changes. You will still have required minimum distributions and now the Social Security tax formula and federal tax rates will be calculated using single rates and threshold amounts. This means a bigger tax bite for a sole surviving spouse in retirement. Roth conversions can help avoid this later-life tax whammy.

4. Medicare Part B and D premiums

With Medicare Part B and D premiums, the more income you have, the higher your premiums. Required minimum distributions count as income. Many people may start off underneath the threshold limits, but once they reach 70 1/2 their income will be higher and now they may be paying an extra couple thousand a year in Medicare premiums. Roth conversions can help avoid this later life cost.

5. Effect on capital gains tax rate

If you can keep your taxable income low in retirement you will also pay tax on capital gains and qualified dividends at a lower rate. If you do your planning right, you might even be able to realize gains during a year or two where you fall into the 0% capital gains tax rate. This is another hidden benefit to having low required minimum distributions from traditional IRA accounts.

Benefits of a Roth conversion

When I run retirement projections I like to use conservative assumptions. I care that you make it in a worst-case scenario. I typically use a real rate of return of 2%, so I assume 3% inflation and a 5% return on retirement accounts (both tax-deferred and Roth.)

I evaluate the benefits of the Roth conversion based on these returns and assuming tax rates are indexed to inflation, but Social Security and Medicare premium thresholds are not. I default males to longevity of age 85 and females to 90. I quantify the potential tax savings, increase in available spending in retirement, or increase in wealth transfer value.

Then I look at what happens if one spouse passes sooner, or investments earn a return higher than 5%. Wow! The benefits of the Roth at that point are incredible. And what if tax rates rise? The Roth will look even better.

The timing of when to do a Roth conversion and the analysis as to whether you should really be making designated Roth contributions instead of deductible 401(k) contributions is complex. There are a lot of moving parts.

I can tell you, more times than not, the Roth looks much better than you would think. Overall, I think people are getting bad advice on the superhero powers of a Roth IRA. It's time for that to change.

If you want detailed research on this topic check out the paper “Roth versus traditional accounts in a life-cycle model with tax risk,” by Marie-Eve LaChance, Journal of Pension Economics and Finance, December 2012.