Problem

I'm 45 and have about $360,000 in a tax-deferred IRA. How do I decide whether to keep it in the regular IRA or convert to a Roth? What are the key differences between the two?

Solution

A Roth IRA allows you to make tax-free withdrawals and doesn't require you to take minimum distributions. With a traditional IRA you have to pay taxes on your withdrawals and start taking minimum distributions when you reach age 70 1/2. The ability to defer withdrawals is a big reason the Roth IRA became so popular.

But before trying to decide whether you want to switch, make sure you qualify for a Roth. That means your modified adjusted gross income (see IRS Publication 590 at www.irs.gov for details) must be $100,000 or less.

Another consideration is how much you'll have to pay in taxes on the IRA money if you convert. If you're in the 34 percent marginal tax bracket, say, your tax liability on the $360,000 in your traditional IRA will be about $122,000. Assuming you have money available outside of your IRA (in an after-tax account) to pay those taxes, the conversion may be worthwhile. If not, the conversion isn't attractive, because you'll decrease the principal from the IRA in order to pay the taxes.

The most popular way to make the decision is to figure the potential income stream from a Roth IRA, then compare that with what you'd get from the traditional IRA and earn on the after-tax money you'd have used to pay taxes on a Roth conversion. You'll have to estimate what annualized growth rate you'll get on your investments and the tax rate that will apply when you retire.

Let's assume a pre-tax investment return of 8 percent annually for 20 years. Both the Roth and the regular IRA would be worth $1,677,945 at that time, because both compound tax-free. If you're in a 32 percent tax bracket when you retire (28 percent federal tax bracket and using 4 percent as an average state tax rate), you'll get $158,243 a year for 20 years from a Roth account, vs $145,400 after taxes from your regular IRA and your after-tax account. Based on this calculation, converting to a Roth IRA would give you an extra $12,843 annually.

But wait! How likely is it that you'll get an 8 percent investment return and be in the marginal tax bracket that you anticipate when you withdraw money? More likely, you won't earn exactly 8 percent each year and tax rates will change by the time you retire. So basing your decision on those assumptions isn't the best route.

I suggest using a more realistic, albeit more complex, calculation: a computer processing method known popularly as a "Monte Carlo simulation," which a financial adviser can run for you. This factors in the odds of a particular future event happening—such as getting an 8 percent rate of return, or your tax bracket being 28 percent when you retire—and requires special software that, typically, only financial advisers have.

When I ran the simulation for your situation, I found that converting to a Roth IRA isn't necessarily wise. There's only a 54 percent chance that you'll do better with a Roth IRA—meaning there's a 46 percent chance you'll lose value by converting. Given those odds, I'd recommend that you stick with your traditional IRA.

This issue's problem solver is Glenn G. Kautt (kautt@themonitorgroup.com), CFP, a financial adviser and president of The Monitor Group in McLean, VA. Financial Problem Solved! is edited by Senior Editor Leslie Kane.

 

Leslie Kane. Financial Problem Solved! Medical Economics Jan. 9, 2004;81:87.