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Roth IRA Conversions

Do They Make Sense?

The Answer will Shock You!

Roccy DeFrancesco, JD, CWPP, CAPP, CMP

The Wealth Preservation Institute

144 Grand Blvd

Benton Harbor, MI 49022

269-216-9978

www.thewpi.org

Roth IRA conversion basics

• What is a conversion?

• When you take a tax-deferred IRA and “convert” it

into a Roth IRA.

• Upon conversion, income taxes are due on the

entire balance.

• However, after the taxes have been paid, the

money in a Roth grows tax-free and can be

removed tax-free in retirement.

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Continued

• If you convert under the age of 59.5, the 10%

penalty is waived.

• However, when you convert to a Roth IRA, you

must wait 5 years before removing the money to

avoid the 10% penalty.

• The $100,000 limit on converting an IRA to a Roth

IRA went away and there is an unlimited ability to

convert to a Roth IRA.

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Why convert?

• It sounds good in theory.

• Taxable IRAs can be tax-hostile because when

you take the money out, you will pay income taxes

on distributions.

• Roth IRAs while funded after-tax allow money to

grow tax-free and come out tax-free.

• Therefore, in hindsight we made a mistake

deducting contributions to a taxable IRA (or

qualified plan).

• Right?

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Conventional wisdom?

• Many talking heads, article writers, and computer

programmers are telling us that Roth IRA

conversions are good.

• Unfortunately they are wrong.

• The conclusion that you will draw from this

presentation is that IRA Roth conversions do not

make sense for most people if the goal is to

maximize spendable dollars in retirement.

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How do you know if a

conversion makes sense?

• The simplest way is simple to “run the numbers.”

• The great thing about math is that when it’s done

right, it doesn’t lie.

• But as you probably know, math can be

manipulated very easily by the assumptions/inputs

used to drive the calculations.

• Therefore, it is vital that you understand all the

variables that are needed to determine if a Roth

IRA conversion makes sense (and how I

constructed the new Roth IRA conversion calc). 6

The variables…

• The classic variables that everyone discusses:

• 1) Age

• 2) Amount of money in a non-Roth IRA prior to

conversion

• 3) Current income tax bracket – Problem is most calcs. do not take into account our progressive tax system

which may lower the taxes due on conversion.

• 4) Future income tax bracket

• 5) Assumed rate of return on investments – The calcs do not allow for an input for mutual funds or other expenses. While

this is an expense in both accounts, it will reduce the available dollars in

retirement. 7

Continued

• 6) Are you using funds from your IRA to pay the

taxes or other funds? – This has a dramatic affect on whether it makes sense to convert. If you are

using money from the IRA itself to pay the taxes, it’s nearly impossible to

make the numbers work.

• 7) Beginning withdrawal year.

• 8) Number of years you want to draw income.

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What variables were omitted

• 1) Filing status for taxes – Again the calculators simply allow for an input of your highest marginal tax bracket.

– Most people hardly know that.

– Therefore, the WPI calc. allows for an input of the client’s AGI and allows them to

pick their filing status.

– It then automatically calculates the actual taxes that will be due on all the client’s

new/additional income that comes from the IRA conversion.

• 2) State income taxes – The calc. needs to allow for the payment of state income taxes if any (not all states

have a state income tax).

• 3) Mutual funds, money management fees, or other

fees levied on money in either the Roth or

traditional IRA – This does not have a great affect on the difference between which one is better,

but you need the input to give a real world look at the amount of accumulation or

retirement income.

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Continued

• The following inputs are needed IF you choose to

pay the income taxes due from the conversion

from NON-IRA funds (which is the only time a Roth

conversion will make financial sense).

• 4) Cost Basis of Assets used to pay taxes— – Some people will have money laying around in CDs, money markets, bank

accounts, or bonds to pay the taxes (no real cost to liquidate and use to pay

taxes).

– However, many people will have to liquidate stocks/mutual funds to pay

the tax to convert their IRA.

– When you sell stocks, short-term and/or long- term capital gains taxes will be

due.

– Those stocks have a “basis” that needs to be taken into account. This input is

for that basis.

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Continued

• 5) Short-/Long-Term Ratio—

– This input tells the software of the stocks you are selling to pay the taxes due

on the IRA conversion what the mix is of short-term and long-term capital

gains taxes on the sale of that stock.

– Some stocks will be sold with a long-term gain and some with a short-term

gain (taxes at the client’s highest marginal rate).

• 6) Short-/Long-Term Capital Gains/dividend tax rate on growth

of the “side fund”—

– To create an apples to apples comparison, if you did not convert your IRA

and pay the taxes from “other funds,” those other funds would still be

growing as part of your portfolio.

– Therefore, when you compare taking money from a taxable IRA vs. a

Roth, you have to add to the funds from the taxable IRA withdrawals to

the money you did not spend on taxes at conversion.

– When the “side fund” grows in the real world, there will be taxes on the gains.

– This is the field where the system pulls the blended capital gains/dividend tax

rate on the annual growth inside the “side fund.”

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And you thought Roth IRA

conversions were going to be simple?

• The fact of the matter is that running real world numbers on

Roth conversions is quite difficult.

• It’s my opinion that the reason you have defective

calculators and articles on the internet that are not accurate

is because it’s complicated to deal with all the needed

variables.

• And therefore, the default position is to put something out

that is easy to understand or use, even though it’s wrong.

• Look at the following screen shot of a typical Roth IRA

conversion calc.

• After what you now know, think of how silly it looks. 12

Classic internet calculator

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My new internet calculator

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Examples

• Using real world math with examples is the only way

to figure out if IRA conversions make any sense.

• Age = multiple (see the next slide)

• Conversion amount $500,000 IRA.

• 7% gross rate of return on money in the IRA, Roth

IRA after conversion, and on the side fund.

• 1.2% mutual fund expense.

• Income starting at age 70 for 15 years.

• Married filing jointly with no state income tax.

• Income (varies) see next slide. 15

Paying taxes from the IRA

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Current Annual Taxes due at

Withdrawal

from

Withdrawal

from Percentage

Age Income Conversion Non-Roth IRA Roth IRA Difference

65 $125,000 $165,487 $47,748 $35,218 -26.24%

60 $125,000 $165,487 $63,297 $46,687 -26.24%

55 $125,000 $165,487 $83,910 $61,890 -26.24%

50 $125,000 $165,487 $111,235 $82,045 -26.24%

Current Annual Taxes due at

Withdrawal

from

Withdrawal

from Percentage

Age Income Conversion Non-Roth IRA Roth IRA Difference

65 $75,000 $160,487 $47,748 $36,077 -24.44%

60 $75,000 $160,487 $63,297 $47,826 -24.44%

55 $75,000 $160,487 $83,910 $63,401 -24.44%

50 $75,000 $160,487 $111,235 $84,047 -24.44%

Paying taxes due on conversion

from “other” non-IRA sources

Current Annual Taxes due at

Withdrawal

from Withdrawal from Percentage

Age Income Conversion Non-Roth IRA Roth IRA Difference

65 $125,000 $165,487 $66,401 $63,664 -4.12%

60 $125,000 $165,487 $86,689 $84,369 -2.68%

55 $125,000 $165,487 $113,267 $111,880 -1.22%

50 $125,000 $165,487 $148,066 $148,314 0.17%

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• The above assumes you have cash to pay the taxes.

• The following assumes you had to sell $50,000 basis stock to pay the tax (where the mix of

long-term and short-term capital gains taxes upon the sale is 50%).

Current Annual Taxes due at

Withdrawal

from Withdrawal from Percentage

Age Income Conversion Non-Roth IRA Roth IRA Difference

65 $125,000 $165,487 $69,827 $63,664 -8.83%

60 $125,000 $165,487 $90,997 $84,369 -7.28%

55 $125,000 $165,487 $118,660 $111,880 -5.71%

50 $125,000 $165,487 $154,831 $148,314 -4.21%

Income taxes going up in

retirement? Does that help?

• The following chart shows you what would happen

if clients earning $75,000 a year have their

income tax bracket go up to 30% as the top

marginal rate in retirement.

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Current Annual Taxes due at

Withdrawal

from

Withdrawal

from Percentage

Age Income Conversion Non-Roth IRA Roth IRA Difference

65 $75,000 $160,487 $65,932 $63,664 -3.44%

60 $75,000 $160,487 $85,884 $84,369 -1.76%

55 $75,000 $160,487 $111,946 $111,880 -0.06%

50 $75,000 $160,487 $146,324 $148,314 1.36%

Using a bonus FIA

• One way to improve the numbers on their face is to use a

“bonus” fixed indexed annuity.

• This is salesmanship.

• If you used a 10% bonus annuity and paid taxes from

cash, a 55-year old earning $125,000 a year (married

filing jointly) who is in the same tax bracket in retirement,

the numbers would look like the following:

– Traditional IRA $77,884.79 Roth IRA $82,904

– Wow, now it works right?

• However, if you used that same 10% bonus in the non-

Roth IRA, you’d be able to take $83,537 out of the IRA +

side fund after-tax. 19

What conclusions can we draw?

• Very simply, converting a traditional tax-

deferred annuity to a Roth IRA will NOT make

sense for the vast majority of Americans.

• This presentation and the calc. simply deal with

people who are thinking of converting their IRAs in

the hopes that they will generate more after-tax

retirement income.

• There are estate planning applications with Roth

IRAs that make them very unique.

• That is outside the scope of this presentation. 20

Cost

• $25 a month.

• This will also be embedded in the full-blown

financial planning software and can be essentially

purchased for less in a bundled manner with that

software.

• Free to those who meet production requirements.

• Free to those who are putting “all” of their business

with Optima.

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Questions

Questions

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