Roth Conversion Analysis

[Kathleen Reynolds]

#4141

Analyzing the potential benefits of a Roth IRA Conversion can be a fairly daunting task. How do you analyze and present the benefits of a Roth IRA Conversion? We’ve found that there are basically three ways.

Guesstimate

You can run some numbers with a hand calculator and approximate what will happen. By getting a quick idea of how things will go, you can prevent yourself from spending time chasing down a bad idea. In the case of analyzing a Roth IRA Conversion, however, this approach is a really bad idea. Here’s an example.

Take the hypothetical case of $100,000 in an IRA. If the income tax rate were 30% and the growth rate were 5%, would it make sense to convert to an IRA? Let’s look at what happens over 20 years. If you left it alone, the $100,000 would grow to become $265,330 after 20 years. Taking income taxes out of that leaves only $185,731. On the other hand, if you converted it now, the $100,000 would be reduced to $70,000 by income taxes. The $70,000 Roth IRA now grows at 5% for 20 years, resulting in $185,731.

No difference! This type of analysis would conclude that converting to a Roth IRA doesn’t result in any benefit. However, it’s also completely wrong. It doesn’t take into account the fact that the IRA can’t be left alone for 20 years. Minimum distributions require it to start being reduced after the owner reaches age 70½ for birthdates on or before 6/30/1949, and age 72 for birthdates on or after 72. It also doesn’t take into account the changing tax bracket. Converting to a Roth IRA probably will likely put your client into a higher tax bracket in the conversion year.

And that’s the crux of the Roth IRA analysis. Does the value of the Roth IRA – with its tax-free growth and no minimum distributions during the owner’s life – outpace the cost of paying higher taxes up front? In many cases, the answer is yes. In others, it’s no. It all depends on the growth rates, tax brackets, and the age of the owner. If you have other assets available to pay the taxes, you have to take them into account also. You can’t approximate this one. You have to run the numbers.

Cash Flow Analysis

Once you’ve decided that you have to run the numbers and see what happens to the balances and distributions, you’re still faced with how to analyze them. One approach is to look at how much benefit (or after-tax dollars) is distributed from the qualified plans. You add up all the net distributions taken from the IRA if no conversion were to happen, and then you compare this total with the net distributions (minus conversion taxes of course) from the Roth IRA if a Roth IRA Conversion were to take place.

If your client is of the “spend my distributions” mindset, this approach is perfect. After setting up your alternatives, print the Net Distributions and Net Distributions Comparison presentations and you’ll get a great presentation to give to your client.

Asset Analysis

If your client is not going to be spending the distributions, however, you should probably look at the analysis from the point of view of the assets. The key difference between the Asset Analysis and the Cash Flow Analysis is that the Asset Analysis takes into account what happens to the money after it has been distributed.

If your client is not spending the minimum distributions, you need to include the accumulation of them in the analysis. These moneys can add up to quite a significant sum, and definitely decrease the advantage of converting to a Roth IRA.

For this approach, use the Asset Analysis and Asset Comparison presentations to illustrate the benefit (or cost) of a Roth IRA Conversion. To show the full value to the heirs, select the “Including Stretch” versions of these reports.

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