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.
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!