I love Roth. That is Roth IRA’s.
You may have already figured it out due to the amount of posts I’ve written on the topic. If you didn’t know that or aren’t familiar with the concept of a Roth IRA, I suggest checking out one of the following posts I’ve already written on the topic:
- Traditional 401(k) vs. Roth 401(k)
- What is a Backdoor Roth Conversion?
- Should I Contribute to an IRA?
- What is a taxable account?
- The Best Christmas Gift
This year I decided to make a proactive Roth conversion. It’s important to note that this is different from a Backdoor Roth Conversion like I talked about in the post I reference above. A Roth Conversion is taking dollars from a current Traditional IRA (pre-tax) and moving them into a Roth IRA (after tax). The process of moving funds from a Traditional IRA to a Roth IRA is a taxable event and each dollar converted is recognized as taxable income for that tax year. Don’t get too hung up on the extra tax part because the reward is having those dollars in a Roth IRA that will grow tax free indefinitely.
So why did I decide to recognize additional income in 2020 and willingly pay more taxes?
Let me explain the best way I know how, with a little math!
The Math
I shared with you in a past post that early in my career I opened a contributory IRA and contributed a bit each year. I look back at that now and think of that as a financial misstep. Not saying it’s a bad thing to save into a traditional IRA, any type of savings is a positive, but knowing what I know now I would have instead increased my 401(k) contributions those years targeting my Roth 401(k) or saved into the Roth IRA. Oh well, live and learn.
Getting off track…
I have this contributory IRA that I’ve stopped adding to years ago when the contributions were no longer fully deductible (i.e. I made more than the annual income limit which in 2020 is $65,000 for a single individual or $104,000 for a married filing jointly couple). To keep the math simple, I’ll share that I have $14,000 sitting in my Traditional IRA. The Roth conversion is going to cost me roughly $3,360 in extra taxes this year as I will pay ordinary income tax on each dollar converted. That is a lot of money, but I promise there is a method to this madness.
Let’s say I keep the $14,000 invested in the pre-tax IRA environment. Over the next 30 years, assuming an investment return of 7%, that same $14,000 will grow to $106,571. In retirement I would eventually need to take distributions from the account to offset living expenses and pay ordinary income taxes on each dollar distributed. To make the point and math simple, if I were to withdrawal that entire amount in one year to cover retirement expenses, the taxes would equal $25,577 leaving me with only $80,994 of purchasing power after taxes.
In making a Roth Conversion, I am moving the $14,000 into a Roth IRA environment and letting those dollars grow tax-free! Over the same 30 years, assuming an investment return of 7% that same $14,000 will go to $106,571. Oh, and did I mention I never have to pay taxes on that again. By paying the $3,360 today I am saving myself (and future heirs) from having to pay income tax on $106,571 which would translate into $25,577 of taxes.
| Keep Traditional IRA | Make Roth Conversion | |
| Taxes Paid Now | $0 | $3,360 |
| Future Value of $14,000 | $106,571 | $106,571 |
| Taxes Paid @ Distribution | $25,577 | $0 |
| Purchasing Power | $80,994 | $106,571 |
$3,360 of taxes today vs. $25,577 of taxes in the future?
Purchasing Power of $106,571 vs. $80,994 30 years from now?
Which scenario would you choose? In summary, short term pain, long term gain.
Added Benefits
Another benefit of making this conversion is that I’ve now cleared the path to make future Backdoor Roth Contributions. With all my qualified retirement money in either my company 401(k) or Roth IRA, I can now move forward with making backdoor contributions in the years ahead. As a true financial nerd, this prospect makes me very excited, especially when I think of all the taxes I’ll be saving over the long-term.
Who wants to do another math problem with me?
In this exercise we will look at the benefits of saving an extra $6,000 in a Roth IRA vs. a regular taxable account. If I couldn’t contribute to a Roth IRA, a taxable account is where I would invest my $6,000. In the scenarios below, I am assuming growth over 30 years at a 7% rate of return.
| Taxable Account Contribution | Backdoor Roth Account Contribution | |
| Annual Contribution | $6,000 | $6,0000 |
| Taxes Paid at Contribution | $0 | $0* |
| Future Value of $6,000 | $45,673 | $45,673 |
| Taxes Paid at Distribution | $9,521 | $0 |
| Purchasing Power** | $36,151 | $45,673 |
**Don’t forget about capital gains tax! Assuming 24% capital gains tax
Purchasing power of $36,151 vs. purchasing power of $45,673?
I’ll ask the question again, which would you choose?
This example just shows the power of making a Backdoor Roth contribution in one year. Imagine the power of contributing annually over the next 30 years! I’ll do the quick math for you, 30 years of Backdoor Roth contributions, assuming a growth of 7% per year, on top of the initial $14,000 conversion is $673,336! And that is straight purchasing power.
Do I need to go on?
Forward Looking
To summarize all of this, I made the decision to convert my entire Traditional IRA into a Roth IRA this year and am paying $3,360 in taxes. I’m doing this for two reasons:
- The $14,000 I’m converting today could one day be worth over $100,000 tax-free.
- Ability to make Backdoor Roth Contributions for the next 30 years + while working which could translate into over $600,000 tax-free.
I don’t know about you, but seeing these numbers gets me very excited about my financial future and the options I’ll have down the road. Another point I’ll add is that income taxes are close to historical lows which is even more incentive to convert dollars this year under the current tax rates. There is a strong chance that if rates do change in the years to come, they will only go up.
If this post has got you thinking you’d like to learn more about Roth IRAs or understand if converting your Traditional IRA into Roth makes sense within the context of your finances…don’t be a stranger! If you couldn’t tell, I love these discussions and looking at the math.
You forgot to factor what the 3&1/3 grand could grow to if invested. Seems like a wash.
I thought of that but you’d have to factor in the taxes when that $3,000 is distributed. The idea is that with the Roth IRA you maximize your purchasing power because no taxes are taken at distribution.
The $3,360 taxes paid on Roth conversion would grow to PV of $25,577 in 30 years and is subject to capital gains tax or step up basis. Also, the scenario assumed the TIRA would be 100% distribution at 30 years. That is likely a higher tax bracket than if the TIRA were distributed over lifetime via RMDs.
I think Roth makes sense if the tax bracket on a conversion is less than taxes on RMDs. If you pay 22% to convert now instead of keeping in TIRA and paying 22% tax on RMD, it’s a wash. There are other reasons for Roth, including leaving tax-free to heirs.
You make a great observation on the distribution schedule of the future Traditional IRA. To keep things simplistic I went the route of a one-time distribution to demonstrate how taxes are assessed those distributions. It’s a worthwhile exercise if you believe your tax rate will be higher in the future. I am in that camp.
I have been running all sorts of streadsheets on this and its a bit of a pain, due to the various tax brackets that need to be accounted for. But when I run things and also factor in the extra taxes paid now, It always seems like a wash, and Clearly your age is a significant thing because if you are 65 or older your outlook is very much different. I with someone like yourself could do this in a spreadsheet that might convince me that this is really a good decision as we could be talking a lot of tax, which would deplete all cash reserves. I do not see this as such an obvious decision as many people think it is or younger people, or people with smaller size IRAs.
This is my main issue also because when I run a spreadsheet (which includes tax implications), I keep getting an almost wash result. And depending on amounts, which change the tax implications, sometimes its not actually a good decision. Has anyone out there done spreadsheets that take these things into consideration?
You forgot to deduct the $3,360 you paid in taxes from the $14,000 you’re investing. There are lots of good reasons to transfer your money from a traditional IRA to a Roth IRA, especially if you believe that your present tax rate is lower than your future tax rate. But if the tax rates are the same, the math is the same.
Here’s my situation. I have about $1 million in a traditional IRA and about $1 million in a Roth. Let’s say my effective tax rate is 30%. If I were to take the million out of my traditional IRA and put it in my Roth, I’d pay about $300,000 in taxes. So then I’d have $1.7 million in my retirement accounts. Let’s say my CAGR is 10%. In ten years, I’d have $4.4 million.
Now let’s say I just leave my IRAs alone. In ten years, I’d have $5.2 million. Let’s say I withdraw that at the SAME TAX RATE AS NOW. I’d pay no taxes on the $2.6 million in my Roth but I’d pay 30% tax on the $2.6 million in my traditional IRA. That leaves me with . . . yes, $4.4 million. The exact same amount.
It was intentional not to factor the taxes out of the $14k. Those dollars will be paid with money sitting in a savings account so I can maximize the amount converted. Your point on tax rates staying the same is valid which is why Roth Conversions are not a one size fits all solution. In my personal case, I believe my tax rate will go up overtime as I grow in my career and I also believe that income tax rates are at historical lows and will only go up in the future.
Yuval,
First, congratulations in being in the position of having reached the rarified position, financially, that 98% of Americans will never reach!
Your reasoning is sound, however you have to ask yourself a question or two.
1. Do you REALLY believe that Congress will forgo raising taxes, considering the Trillions they are spending today, to buy votes and pay off the liberal states responsible for their election, under the guise of COVID Relief? Your comparison assumes taxes are going to stay level.
2. Even if you are one of those people who believes in big government, are willing to gamble on rates staying the same, when you KNOW rates today are at some of the lowest in our country’s history? Take a look at the History of US Taxes on the following link, or check Ed Slott’s new book, “The New Retirement Savings Time Bomb.”
/Users/imac2/Library/Containers/com.apple.mail/Data/Library/Mail Downloads/9FA3B63F-DC5F-4A11-A6FB-498CFB4C9BD7/History of Top Tax Rates.pdf
For the average American, Roth Conversions are the answer to a safer, better, stress free retirement. Smart young people, like the author of this blog, should begin stuffing as much money into Roth IRAs, and if available, Roth Elections within their 403b and 401k accounts. The traditional IRA is a trap. Its purpose has been perverted from its original use to being a slush fund for Congress and the IRS.
While the rules are in place, maximize the benefit. Congress can and has changed the rules to suit themselves in the past, and will do so again in the future. However, when they do, they usually grandfather in past dollar amounts.
For transparency, I am a college professor and I teach Retirement Income Planning, among other financial planning topics. I began my Roth conversion strategy in 2018, when Roth Election was added to my 403b account. While I have been paying very high taxes for 2 years and I will for 2 additional years, when I (we) retire, my wife and I will have ZERO dollars in tax deferred accounts. I (we) will still have a brokerage account with taxable income, for flexibility, and our social security income, which I waited to claim until I turned 70, last year…and we should be in the 12% tax bracket (15% after the TCJA sunsets.) Depending on what Congress does to Social Security, we may be in a tax bracket low enough to avoid any taxes on our SS Benefits, although enjoying a very low 6 figure retirement.
All because of Roth Conversions.
While Maureen is undoubtedly too young to remember this advertisement from Fram Oil Filters, the IRS is just like the slogan they used on TV, “Pay me now or pay me later.” I hope more young people learn the rules of the IRS game early!