Roth Conversions; No Free Lunch – Part 1 of 4

 

There is no more enjoyable dinner in my household than a meal that involves steak. My 12-year-old and I prefer ours medium rare, while my wife and 16-year-old choose whatever comes after well done. Irrespective of our idiosyncratic tastes in how a steak should be cooked, I assume we are not alone. This may explain why annuity presentations and financial advisor steak dinners have historically gone hand in hand. People actually like steaks!

Annuities are becoming less of a hot steak topic. The newest subject to hit the meat markets is Roth conversions. What is a Roth conversion and does the advice to convert make sense? I will explore both of those questions in upcoming essays.

Roth conversion...

Converting an account to a Roth IRA involves moving assets from a pre-tax or tax-deferred account, such as a Traditional IRA, into a Roth IRA. In doing so, and assuming all applicable rules are followed, no taxes will ever again be paid on either the amount post conversion or future gains.

Many people ask, why would anyone not do this? The answer lies in what happens during the conversion process.

When assets are moved from pre-tax to Roth, the amount converted is subject to ordinary income taxes in the year of conversion. Therein lies the decision hurdle, in the Roth conversion process. The long-term goal for most individuals is the minimization of taxes, within the confines of the legal system, of course, but the minimization of opportunity costs must also be considered.

If taxes are going to be paid regardless, and minimization is the objective, does it make sense to pay taxes now by converting pre-tax assets to a Roth, or is it more optimal to pay taxes on those assets over time? The tax paid on the amount converted serves as the foundation and corresponding break-even determinant for the decision at hand.

The conversion break-even point, simply put, is the moment when a decision begins to pay off. It is the point of equilibrium at which, regardless of the time elapsed, you are in the green. Put another way, it is the point at which the total taxes previously paid through Roth conversions are exceeded by the cumulative taxes paid under the alternative of not performing the conversions. Moving past the breakeven, it will have made sense to convert the assets.

As always with a break even, time is of the essence and will be further discussed in essay part 2 of 4...

Summary:

It’s easy to approach Roth conversions emotionally, but the decision deserves disciplined analysis. As Vanguard Group has noted and as I will explore further in Part 4 of 4, a BETR analysis provides a more complete framework for evaluating the tradeoff. At the center of the decision is the break-even point, where the cumulative taxes paid through conversion are finally offset by the taxes that would have been paid had no conversion occurred. The real issue is whether the strategy clears that economic hurdle, whether the time horizon is long enough for the benefit to materialize, and the impact of exogenous factors.

The underlying break-even will be further explored next in part 2 of 4.

Want to discuss if strategic Roth conversions make sense?