Roth IRA Conversion Calculator Explained

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In 1998, the Roth IRA was introduced. Since then, many people have converted all or a portion of their existing Traditional IRA’s to Roth IRA’s, where distributions are eventually tax free. When converting from a regular IRA to a Roth IRA, the amount of the conversion is taxable in the year of the conversion.

This law is changing, starting in 2010, anyone who converts to a Roth will pay no taxes that year, taxes will be due in 2011 and 2012. If there ever was a time to convert, 2010 is it. But like everything else, you need to do your homework. Let’s take a look at the Roth IRA Conversion calculator…

Roth IRA Conversion

The purpose of this calculator is to figure out whether or not a conversion to a Roth IRA from a traditional IRA, SEP, old 401K etc. makes sense. I’m going to say the large majority of the time it’s going to be worth it. But there’s always two sides to every coin.

If you know (to a degree of certainty) your tax rate is going to drop in retirement (which I don’t know how you would know that) and you are in your mid to late 40’s with a conservative outlook, then run the numbers in the calculator and maybe you should stay put in your regular IRA.

For the rest of you, it’s probably going to make sense to start planning a 2010 Roth conversion, if not sooner. But don’t take my word for it, lets take a closer look at this screen shot and define each of the fields…

Amount to Convert

Currently, anyone with an adjusted gross income over $100,000 is not eligible to do a Roth IRA conversion (remember that law is scheduled to change in 2010). For the purposes of this calculator, the assumption is that your income does not limit your ability to convert to a Roth IRA.

We also assume that you are paying any taxes owed with funds that you have available outside of the IRA you are converting. (The IRS treats any money not directly transferred to the new Roth IRA as an early withdrawal - even if that money is used to pay the tax bill caused by the conversion.)

If you do not have adequate funds outside of your IRA to pay the tax liability on a conversion, you probably should not consider converting your Traditional IRA to a Roth IRA.

For our example, William Firmatus has $60,000 that he would like to convert to a Roth IRA

Current Age

William is 35 yrs old

Expected Rate of Return

This is the rate of return that the calculator will grow the annual contributions and the underlying asset base. This calculator assumes the return is compounded annually and contributions are made at the beginning of each year. The actual rate of return depends largely on the type of investments you choose. It’s also important to note future rates of return can’t be predicted.

But historically speaking, a more aggressive portfolio will put you in position to attain better results; the trade off being greater risk, mainly in the form of market volatility. From January 1970 to December 2006, the average compounded rate of return for the S&P 500, including reinvestment of dividends, was approximately 11.5% per year (source: www.standardandpoors.com).

During this period, the highest 12-month return was 61%, and the lowest was -39%. Savings accounts at a bank pay as little as 1% or less.

For the purposes of this example I’m using 8.00%.

Tax Rate at retirement

The marginal tax rate you expect to pay on your investments at retirement. This is a very important part of the whole equation and can have a big impact on the calculator’s results. Not knowing where future tax rates are going to be, makes it hard to know what to put in this field.

The classic assumption is since you are retired and you no longer earn a wage that your taxes drop. This is generally still the case but with taxable pensions, social security, dividend income and traditional IRA distributions treated as ordinary income, the line gets blurred.

When I model retirement plans for clients, we generally look to maintain 80-85% of pre-retirement income during the retirement years. So logically, in the above example, I’ve chosen to model a proportionate tax rate during retirement.

For the purposes of the calculation, it’s better to model a worse case scenario (or more conservative approach) so that way you’re not surprised later on.

In the above example, I chose to use a retirement tax rate of 25%, which is 83% of the pre-retirement rate used (30%), in line with the 80-85% of pre-retirement income we try to maintain.

Non-deductible contributions

Amount contributed to the Traditional IRA you are converting that was not tax deductible. Remember having a non-deductible IRA is not a bad thing if you plan to do a Roth conversion in 2010.

William has no non-deductible contributions. All his contributions have been deducted from his gross income.

Age at Retirement

Desired age at retirement.

I’m using age 66.

Current Tax Rate

Current marginal income tax rate that will apply to the conversion amount. Please note that the marginal tax rate for your conversion may be higher than your current marginal tax rate if the conversion moves your AGI into a higher income tax bracket.

I’m going to stick with our 30% tax rate for William F. Notice that our conversion amount is $60,000, of which 30% or ($18000) is owed in taxes. You will see that $18,000 number again, as it is used by the calculator to further compare the benefit/drawback of converting to a Roth IRA.

Investment Tax Rate

Expected long term capital gains rate for investments. Why is that in this calculator? OK try and stay with me here because this one is a doozie. In the above screen shot, this is the rate that, the future value of our $18,000 in conversion taxes, would have been taxed at, when William reaches retirement… its purely here for comparative purposes. And I think a bit unrealistic to boot.

The calculator assumes that the $18,000 grows at a compounded rate (in a taxable investment account) and when the investment is sold in 30+ years it’s taxed at the current long term capital gain rate of 15%.

I thought that was a bit unrealistic and changed the rate to 20%, to account for slippage over that time frame, in the form of taxable dividends and capital gains. But once again, it’s not a bad thing, to be conservative in our assumptions.

In Conclusion

From our example it makes sense to convert to a Roth IRA, to the tune of $39,857. The only thing worth comparing is the 1st and 3rd columns. The 3rd column (cream color) is only a hypothetical situation that really brings home the power of the conversion.

One of the major reasons I like the Roth IRA is because once you have one in place, you no longer have to worry about future tax rates… end of story. If you can handle the conversion tax burden now (and plan for it), a Roth conversion becomes a very sensible move and takes away a lot of the tax rate guesswork down the line…

Tags: 'Down Home' Financial Calculators, 2010 Roth IRA Conversion Event, Roth IRA Calculators, Roth IRA Conversion