Now that all of my IRAs are at Vanguard, I can decide whether to convert my $5,000 Traditional IRA to combine with my Roth IRA. After reading up on some pertinent articles at Fool.com and Fairmark.com, here are my thoughts.
Right now I am currently eligible to convert, as my modified adjusted gross income (MAGI) is less than $100,000, after reading this article on eligibility. This will probably not be the case in the future. Also, I have the cash available for the taxes that I will have to pay during the conversion. That way, I won’t have to take the money out of the Traditional IRA, and the $5,000 will then be post-tax instead of pre-tax. Finally, I don’t intend to contribute any more money to a Traditional IRA in the foreseeable future.
Much of the talk about Traditional vs. Roth IRA is about whether you tax bracket will be higher or lower when you retire. However, since that is about 40 years away, who know what the taxes will be by then? Some people even say that earnings on Roth IRAs may be taxed as well later on. I personally like the thought of having all of my non-401k retirement funds in a post-tax account, to hedge my bets between pre-tax and post-tax scenarios.
Finally, it’s time to do some math. There are numerous calculators out there, but the math isn’t hard, so let’s get to it.
Assumptions
Annual investment rate of return (pre-tax) – 8%
Annual investment rate of return (post-25% tax) – 6%
Current Tax Bracket – 25%
Retirement Tax Bracket (best guess) – 25%
Time until retirment – 35 years
Scenario #1: Stay with Traditional IRA
$5,000 x (1.08)^35 = $73,927 (pre-tax)
After taxes, I would end up with $73,927 x 75% = $55,445
However, I would be saving the amount to pay the tax on the potential $5,000 Roth conversion ($5,000 x 25% = $1,250), which could have been saved in another taxable account and invested:
$1,250 x (1.06)^35 = $9,608.
So my total amount of money post-tax would be 55,445 + 9608 = $65,053.
Scenario #2: Convert to Roth IRA
$5,000 x (1.08)^35 = $73,927 (post-tax)
So according to my calculations, I would end up $8,874 ahead in the end if I convert to a Roth. Of course my calcs may be wrong or I may be missing something (If so, please tell me!). I’ll ponder it a bit longer, but I will probably initiate this conversion by the beginning of next week.
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Your math looks okay to me. I would go with the Roth. It offers advantages when you retire. The ability to NOT have to take withdrawals is nice.
JLP
http://AllThingsFinancial.blogspot.com
On the otherhand… I like not paying taxes, and letting the money compound. Different strokes.
There is no rule against having both a Traditional IRA AND a Roth IRA for any given year, as long as you don’t exceed the maximum contribution between the accounts. Remember that your contributions to your T.IRA may be tax deductable, depending on your current contributions to a 401K and your income. Use this to your advantage.
Put some amount of money into your Roth IRA, but leave room for some financial magic come tax season. This is increasingly easy with the rising allowances for contributions. At the end of the year when you’re doing your taxes, take the time to figure out whether purchasing a T.IRA will be beneficial to you.
My situation was as follows: I was limited to contributing $2000 (tax-deductable) to a T.IRA for 2004. Before making those contributions, I owed about $230 in income tax. After making those contributions, I was refunded about $420.
Assuming I use that difference in my refund ($650) to fund my Traditional IRA (along with $1350 of my own money) I now have a $2000 investment for $1350, an immidiate return of about 45%. Had I maxed out my Roth IRA instead, I would’ve simply paid the government $230 and had a $0 investment.
The error in your calculation is here:
$1,250 x (1.06)^35 = $9,608
Which should really be:
$1,250 x (1.08)^35 = $18,481, added to your $55,445 gives a total of $73,926
NO DIFFERENCE IN A ROTH IRA IF YOUR TAX RATES ARE THE SAME!!!
Thanks for the comment! DEW, your calculations are true if the source of taxes due on conversion are funds FROM your IRA. However, if the source of taxes due on conversion are from OUTSIDE of your IRA, which is the case here, then my calculations are correct.
Funds FROM your IRA could have earned that 8% annually.
Funds from OUTSIDE your IRA would have only earned 6% since they would have been subject to tax each year, using these assumptions.