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# When to Consider Converting to a Roth IRA

### Converting traditional IRAs to Roth IRAs can preserve wealth through tax efficiency

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Here's the big picture - converting traditional IRAs to Roth IRAs can preserve wealth through tax efficiency. Traditional IRAs are funded with pre-tax dollars and grow tax-deferred. Generally, when you withdraw funds, they are taxed at ordinary tax rates. Roth IRAs work the opposite way; they are funded with after-tax dollars and grow tax-deferred. In addition, when you withdraw funds from a Roth IRA, you are not taxed on the withdrawal.

So, why might you consider converting your traditional IRA to a Roth? What are the potential benefits or drawbacks? There are five factors we evaluate:

• Income tax rates
• Ability to pay taxes on the conversion with non-IRA assets
• Estate tax
• Minimum distribution requirements

### Income Tax Rates

Let's go back to a mathematical property that we all learned in elementary school: the associate property of multiplication. If you are like me, you probably forgot about this property shortly after learning it. The property states that if all you are doing is multiplying factors, the product will always be the same regardless of the order in which you multiply them.

This mathematical property can be applied to traditional IRAs and Roth IRAs. Assume you earn \$100 today and have a choice of funding a traditional IRA or a Roth IRA. Additionally, assume you are in the 25% tax bracket today, the 25% tax bracket ten years from now and over that period your investment doubles in value. If you fund a traditional IRA today, you will fund it with pre-tax dollars; therefore, the \$100 you earned is not taxed, and you can put the entire \$100 into the traditional IRA. Over the next ten years the \$100 doubles in value to \$200. Then, you withdraw the funds to spend it. You pay tax at a rate of 25%, or \$50, leaving \$150 available to spend. Alternatively, if you decided to fund a Roth IRA today, you would have to pay tax on the \$100 of earnings because you do not get a tax deduction when you fund a Roth IRA. Therefore, you pay 25% on the \$100 of earnings and have \$75 available to fund the Roth IRA. Over the next ten years the \$75 doubles in value to \$150. Then you withdraw the funds to spend it. You do not have to pay tax on the withdrawal, so you have \$150 to spend. Whether funding a traditional IRA or a Roth, if you assume the tax rates are the same today as they are in the future, the amount you can spend will be the same.

So, what does this tell us?  Income tax rates matter.  Traditional IRAs are favorable when tax rates are higher now than in retirement. Roth IRAs are favorable when tax rates are lower now than in retirement.

### Ability to Pay Taxes on the Conversion With Non-IRA Assets

When a traditional IRA is converted to a Roth IRA, income taxes must be paid on the converted amount. If you can pay those taxes using non-retirement funds, then a Roth conversion might be favorable. To better understand this, let's go back to yet another mathematical property that we all learned in elementary school: the transitive property of inequality.

If you are like me, you forgot about this one too. This property states that if A = B, and C > B, then C > A. So, let’s apply this to Roth conversions.

Assume you earn \$100 and are in the 25% tax bracket. If you fund a traditional IRA, you have a \$100 pre-tax account (A). If you fund a Roth IRA, you pay the tax now and have a \$75 after-tax account (B). If you assume a 25% tax bracket, the amount you can spend (or the after-tax amount) is the same. In retirement, if you were to withdraw the \$100 from the traditional IRA you would have to pay taxes on the withdrawal and would be left with \$75. So at that point the \$100 traditional IRA (A) = \$75 Roth IRA (B). Now, let's assume you convert the traditional IRA of \$100 to a Roth IRA today and paid the \$25 of taxes with non-retirement assets. As a result, your \$100 traditional IRA is now a \$100 Roth IRA (C) So, what is worth more? \$75 Roth IRA (B) or \$100 Roth IRA(C)? It's not a trick question. The \$100 Roth IRA (C) > than the \$75 Roth IRA (B.) This means the \$100 Roth IRA (C) is also greater than the \$100 Traditional IRA (A).

When you pay taxes on a Roth conversion from outside assets, you effectively transfer assets into your Roth account from your outside account. You have effectively transferred assets from a potentially taxable account to a tax-free account, and as a result, reduced the tax drag on your investments.

Fortunately, the next three factors are not quite as extensive.

### Estate Tax

An estate tax is imposed on the fair market value of a property in your estate. With regards to traditional IRAs and Roth IRAs, the estate tax does not make adjustments for the fact that one is pre-tax and the other is after-tax. So, if you have \$1,000,000 in a traditional IRA, that amount is includable in your estate. Assuming you are subject to estate tax, the full amount is taxable at a rate of 40%. If you were to convert the traditional IRA to a Roth IRA prior to your death, and let's stick with the assumption of a consistent 25% income tax rate, then the Roth IRA value would be \$750,000, and that value would be used for estate tax purposes. In this example, you have reduced your estate by \$250,000. Assuming an estate tax rate of 40%, that could potentially result in an estate tax savings of \$100,000.

### Minimum Distribution Requirements

With traditional IRAs, you are required to take a minimum distribution upon reaching age 70 1/2, whether you want to or need to, and they continue for the duration of your life. These distributions are taxed as ordinary income, and the amount of the distribution can be substantial. If you don't need the funds from your traditional IRA, then the required minimum distribution can be pretty tax-inefficient, because you are forced to take money out that you don't need, pay tax on the distribution and then transfer any excess amount you don't spend to a taxable account - reducing the opportunity for continued tax-deferred growth. Roth IRAs don't have required minimum distribution for the original owner. If you don't need to spend the funds, you can allow them to continue to grow tax-deferred, and potentially tax-free, for the duration of your life.

Taxes are complicated. Additional considerations to plan for are the taxation of Social Security benefits, the Medicare surtax of 3.8%, and the amount of your Medicare B premiums. Your income influences all of these. As it stands now, distributions from your traditional IRA increase your taxable income, and as a result, can cause a higher percentage of your Social Security benefits being subject to tax, can indirectly cause you to be subject to Medicare surtax, and can also result in a significant increase in your Medicare B premiums. So, with thoughtful planning, all of these can be better managed.

Aaron Leatherwood, CPA, CFP, CWS, MS is a client wealth strategist for Destiny Capital. Aaron builds relationships with his clients by learning about them as well as their families, priorities, concerns, and the impact they want to have on the world. He then partners with his clients to help them achieve their desired outcomes. Learn more about him at http://bit.ly/aaron-leatherwood.

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