Understanding Roth Conversion: A Strategic Approach
When considering a Roth conversion, it’s crucial to move beyond simplistic comparisons of current and future tax rates. Instead, a more nuanced approach involving the Break-Even Tax Rate (BETR) can provide clarity and help determine if converting is beneficial.
1. What is a Roth Conversion?
A Roth conversion involves moving funds from a traditional IRA to a Roth IRA, which means paying taxes now in exchange for tax-free withdrawals in retirement. This decision is often influenced by tax brackets—paying taxes now if you expect to be in a higher bracket later.
2. Introduction to BETR
The Break-Even Tax Rate (BETR) is the future tax rate at which the after-tax value of converting to a Roth IRA equals the value of not converting. If your expected future tax rate exceeds this BETR, conversion is advantageous. Calculating BETR involves considering how you pay conversion taxes and the composition of your IRA.
3. Factors Influencing BETR
- Source of Funds: Paying conversion taxes from a taxable account can lower BETR, making conversion more attractive. For example, if you pay taxes from a tax-efficient portfolio, BETR might be 29.6%, versus 23.5% from a tax-inefficient one.
- Non-Taxable Basis: IRAs with a non-taxable basis (from non-deductible contributions) may benefit more from conversion as only pre-tax amounts are taxed.
4. Example Calculation
Imagine converting $100,000 while in a 35% tax bracket, expecting a 24% rate in retirement. Without conversion, $100,000 grows to $300,000, yielding $228,000 after taxes. Converting, you pay $35,000 in taxes, but the Roth IRA grows tax-free to $300,000. The BETR here is 23.3%, making conversion beneficial as 24% exceeds 23.3%.
5. Strategic Considerations
- Backdoor Roths: Regular contributions to a traditional IRA followed by conversions can lower BETR, enhancing the appeal of conversion.
- Professional Advice: Calculating BETR and understanding its implications may require a financial advisor, especially for complex scenarios.
6. Conclusion
Roth conversion isn’t just about tax rate comparison; it’s a strategic decision influenced by factors like funding source and IRA composition. Calculating BETR provides a clearer path, helping you decide if conversion aligns with your financial goals. Consulting a financial advisor can offer personalized insights, ensuring an informed decision.
