Tax Cliff Enhances Potential Benefit of Roth IRA Conversion

With US federal tax rates poised for a potential hike next year, now is a good time to consider converting retirement assets to a Roth IRA. Conversions are now available to all investors, with no income ceiling in place.

In a Roth IRA, the investor pays ordinary income taxes up-front on contributions, rather than when the money is withdrawn. This has two advantages. It frees investors from having to take required minimum distributions (RMDs) by age 70½. And, it allows the assets to grow on a tax-free, rather than tax-deferred, basis. That’s where the potential big win lies.

For investors who plan to convert to a Roth IRA, it makes sense to do so at the lowest tax rate possible. That argues for acting now, before the tax hike that will take place on January 1, 2013—unless Congress acts to prevent it.

To quantify the value of a Roth conversion in two different tax scenarios, we modeled the results for a 65-year-old investor who has $1 million in a traditional IRA, allocated 60% to global stocks and 40% to bonds, and personal investments of approximately $400,000 to cover the tax cost of conversion. We also assumed that the investor won’t touch the IRA assets for 20 years, so they can keep growing, and state taxes of 6.5%.

The benefit of lower taxes would, of course, vary with the growth in assets. We used our Wealth Forecasting Systemsm to project 10,000 reasonable outcomes over the next 20 years. In the median case, a Roth conversion would generate $170,000, or 17% higher returns after taxes and inflation for the $1 million account, as the display below shows. If federal ordinary-income rates rise by almost five percentage points next year and the investor converts ahead of the tax hike, the benefit more than doubles to $360,000 over a traditional IRA.

The Advantage of a Roth Conversion Ahead of a Tax Hike

If the investor plans to leave the assets to his or her children, the latter would inherit a far larger IRA, which they could grow for additional decades, although they would be subject to a required minimum-distribution schedule. 

A Roth conversion is not for everyone. Investors who expect to spend down their IRAs or pay a lower effective tax rate in the future are likely to do better without a conversion. But with higher potential tax rates looming on the horizon, a Roth conversion is worth a second look for many investors.

AllianceBernstein does not provide tax, legal or accounting advice. In considering this material, discuss your individual circumstances with professionals in those areas.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio- management teams.

The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.                  

Daniel B. Eagan is Head of the Wealth Management Group at Bernstein Global Wealth Management, a unit of AllianceBernstein.                     

Daniel B. Eagan

Daniel B. Eagan is a Managing Director and the Head of Bernstein’s Wealth Management Group; he assumed his current role in 2011. A member of the Private Client Investment Policy Group, Eagan joined Bernstein in 2001 as a senior portfolio Manager; in 2003 he assumed the leadership of Bernstein’s private client practice in the Northwest. Prior to joining the firm, Eagan was a senior portfolio manager and managing director with BlackRock for seven years. From 1986 to 1994, he worked in investment consulting, most recently with Mercer Investment Consultants. Eagan earned a BS in finance from the University of Illinois and an MBA with distinction from DePaul University.

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