Another Way to Look at Roth Conversions

Now that the limits on conversions from traditional IRA accounts to Roth IRA accounts have been removed, and even 401(k) balances can be converted to Roth, there is a lot to consider here. For many of us, the prospect of converting a large IRA or 401(k) balance to Roth, and having a substantial tax bill as a result, is a little daunting. How should we think about this complex issue?

We have published a few letters on this, and there are many other pieces that outline all the main issues, which you should consider carefully. Factors such as your age, your expected portfolio returns, and your current and future tax rates all have significance here. Consider these issues carefully and discuss them with your tax advisor.

Having considered these factors, this might prove to be a useful way to think about the issue: think about a traditional IRA or 401(k) balance as an asset which has a debt attached to it, much like a mortgage is attached to your house.

EXAMPLE:

IRA balance = $200,000
 “Debt” – the tax you owe – is your current tax rate (state and federal) times your balance, e.g.:
 $200,000 * 47% combined net tax rate = $94,000.

What this means is that if you convert this balance to Roth this is the tax you would pay now. You can pay now (i.e., by converting to Roth) or pay later (by doing nothing now).

The Big Difference

This debt is very different from any other debt you have, however; it does not have a rate of interest you pay, the debt goes up based on the returns of your portfolio, and it also goes up or down based on changes in tax rates in general and your tax status in particular.

EXAMPLE (10 years later):

Portfolio appreciation @ 7%/year = a balance of about $400,000
 New effective combined personal tax rate = 55%
 New tax liability – the “debt” - $220,000

Between the 7% market appreciation and the increase in tax rates, the annual compound increase in tax liability was almost 9%. That is expensive debt – would you borrow money from the government at 9%?  Just asking…

Please remember that markets may fall, tax rates may go down, and other factors may intervene. This is only an example. And we have not discussed the potential for donating IRA assets or the effect on your estate if you leave IRA assets to your heirs. Talk to your tax advisor before making any decisions, please!

Hewins Financial Advisors, LLC d/b/a Wipfli Hewins Investment Advisors, LLC (“Hewins”) is an investment advisor registered with the U.S. Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940. Hewins is a proud affiliate of Wipfli LLP. Information pertaining to Hewins’ advisory operations, services and fees is set forth in Hewins’ current Form ADV Part 2A brochure, copies of which are available upon request at no cost or at www.adviserinfo.sec.gov. The views expressed by the author are the author’s alone and do not necessarily represent the views of Hewins or its affiliates. The information contained in any third-party resource cited herein is not owned or controlled by Hewins, and Hewins does not guarantee the accuracy or reliability of any information that may be found in such resources. Links to any third-party resource are provided as a courtesy for reference only and are not intended to be, and do not act as, an endorsement by Hewins of the third party or any of its content or use of its content. The standard information provided in this blog is for general purposes only and should not be construed as, or used as a substitute for, financial, investment or other professional advice. If you have questions regarding your financial situation, you should consult your financial planner, investment advisor, attorney or other professional. Hewins does not provide tax, accounting or legal services.
Roger Hewins
Roger Hewins

President

Roger Hewins is the President of Hewins Financial Advisors, based in North Palm Beach, FL. Roger has more than 30 years of experience in investment management, helping bring the sophisticated financial advice typically reserved for large institutional clients to everyday investors, from high-net-worth individuals and families to small businesses and retirement plans.

No Comments Yet

Comments are closed

Another Way to Look at Roth Conversions

time to read: 2 min