Think You Missed the Boat on Roth Conversion?

Not likely. As long as you don’t expect to spend down all of your IRA assets, our research suggests that converting your traditional IRA to a Roth IRA can save you plenty on taxes. Conversion would have saved you even more before the American Taxpayer Relief Act (ATRA) took effect in January, but that’s water under the bridge now.

Why Convert?

Some tax-management strategies let you defer taxes while others let you avoid them. With a traditional IRA, you get to defer taxes on your contributions and on portfolio growth until you withdraw money from the account (required minimum distributions, or RMDs, begin at age 70½). At that point, you pay tax at your ordinary income-tax rate, not the lower rate that applies to qualified dividends and long-term capital gains.

When you convert a traditional IRA to a Roth IRA, you pay income tax now on the money you transfer in order to avoid paying taxes later. If you pay the tax with money from outside the IRA, more of your wealth will then grow in the tax-free environment of the Roth IRA, which is more beneficial than the tax-deferred environment of the traditional IRA. That’s the great benefit of conversion. There’s a secondary benefit, too: Because no distributions are required from a Roth IRA, you free yourself from RMDs that could push you into a higher tax bracket.

What Our Research Shows

Let’s consider the case of a 65-year-old investor who has $1 million in a traditional IRA and $435,200 in a personal investment account that he can use to pay the tax cost of conversion (Display). We assume that the assets won’t be spent for 20 years, so they can keep on growing. In order to make a fair comparison between the two strategies, we also assume that after 20 years, all accounts will be liquidated and taxes paid.

 The Benefits of a Roth Conversion Can Be Large

We estimate that, in the median case, the Roth IRA will have an after-tax advantage over the traditional IRA (plus taxable portfolio) of approximately $200,000 in today’s dollars. If the investor plans to stretch the IRA by leaving it to his children, they will inherit a far larger Roth IRA, which may never be taxed and can grow for additional decades. (When a Roth IRA is stretched in this way, the beneficiaries are obliged to take RMDs over time, which are free of income tax. However, the IRA may be subject to estate tax before it passes to the younger generation.)

This does not mean that everyone should convert to a Roth IRA. The strategy is not suited to investors who expect to spend down their IRAs or to pay a much lower tax rate in the future. Of course, changes in the tax code over the 20-year period, such as limits on the benefit of a “stretch” to younger generations, may reduce the long-term benefits of conversion.  

If you do decide to convert, it’s worth thinking carefully about timing. To spread out and potentially lower the tax bite, you could convert part of your traditional IRA in 2013 and another part in 2014, with a view to remaining in a lower tax bracket whenever you can.  

You should work with your tax professional to determine whether a Roth conversion would be right for you and, if so, how you might best execute it.

The views expressed herein do not constitute, and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.

The Bernstein Wealth Forecasting SystemSM uses a Monte Carlo model to simulate 10,000 plausible paths of return for each asset class and inflation, producing a probability distribution of outcomes. It projects forward-looking market scenarios, integrated with an investor’s unique circumstances and taking the prevailing market conditions at the beginning of the analysis into account. The forecasts are based on the building blocks of asset returns, such as yield spreads, stock earnings and price multiples. These incorporate the linkages that exist among the returns of the various asset classes and factor in a reasonable degree of randomness and unpredictability.

Tara Thompson Popernik, CFA, CFP®

Director of Research—Wealth Planning and Analysis Group
Tara Thompson Popernik was named the Director of Research for the Wealth Planning and Analysis Group in 2011 and is responsible for leading research initiatives on investment planning and asset allocation issues facing high-net-worth families, family offices, and endowments and foundations. Previously, she was a wealth management specialist, and before that she was a senior investment planning analyst. Prior to joining the firm in 2003, Popernik was a paralegal in the Capital Markets Group of Cadwalader, Wickersham & Taft. She earned a BA with honors in comparative literature from Dartmouth College. Popernik is a Chartered Financial Analyst charterholder and a CERTIFIED FINANCIAL PLANNER™ professional.

Paul Robertson

Senior Portfolio Manager
Paul Robertson is a Senior Portfolio Manager and a member of Bernstein’s Private Client Investment Policy Group. He joined the firm in 1998 as a research associate and became a research analyst in 2000. In 2004 Robertson was appointed Senior Portfolio Manager and joined the Private Client Investment Policy Group. Between 2007 and 2009 he was also a member of the Alternative Investments team. Previously, he worked as a consultant for McKinsey & Co., Inc.; as a portfolio manager and quantitative analyst for Commonwealth Funds Management, an Australian funds manager; and as an economist for the Australian government. Robertson earned a bachelor’s degree in economics from the University of Melbourne, a law degree from the Australian National University and an MBA from Cornell University.

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