IRAs come in two flavors — traditional and roth. Both have income and contribution limits per year in order to take advantage of their benefits. Roth IRAs require that you pay taxes up front on any income you put into them, but then — this is where the magic happens — your interest grows tax free forever. You can take the total amount out at retirement and not pay any tax on it! You can also pass the total amount onto your heirs without them having to pay taxes. It’s a pretty spectacular deal, especially when you’re in a very low income bracket so you aren’t paying much in the form of taxes up front.
Traditional IRAs, on the other hand, are available for low income earners, often who do not have access to a 401k. With the traditional IRA one would put their money in and not pay taxes on this money up front, but then when they retire and take the money out it’s taxed as income for that year (theoretically your tax bracket would be lower in retirement, but this may not be true.)
Up until recently if you made too much money for an IRA you really couldn’t do anything other than invest in taxable accounts. Traditional IRAs were available but you weren’t able to take the tax deduction up front or when you took the money out in retirement, so the only benefit there was the years of dividends not being taxed and reinvested into your investments. It’s not even that great of a deal because then you’re paying income tax rates on your dividend yields versus dividend rates. Generally traditional IRAs for high income earners are useless.
However for tax benefits, today a higher income earner can do a little trick called a Roth IRA conversion. This occurs when the individual puts up to the year’s limit in a traditional IRA ($5500 currently) and then immediately converts that to a Roth IRA. Because the individual put in post-tax money and the conversion happened right away, no taxes are owed and basically that higher income individual has gone through a loophole to invest in a Roth. For younger folks in their 20s and 30s the ongoing compound interest and ultimate ability to take out the investments tax free might be better (do your own math to figure out if this makes sense for you.)
The trouble comes when you have multiple IRA accounts. Most often this is from 401k rollovers when you leave a job. A 401k is pre-tax money so if you want to roll that over to a Roth you will have to pay tax on not only the interest earned but also the entire amount of basis. That can be an expensive proposition!
That is where the “pro rata” rule comes in. Understanding how this works is a bit challenging. I’ll try to explain this in simple terms based on my research so it’s accurate and makes sense.
How the Roth IRA Conversion Pro Rata Rule works
At the end of the tax year (not the day you do the conversion) the government will look at all your non-Roth IRA funds to determine how much tax you need to pay. They aren’t nice enough to let you get away without paying taxes on a conversion when there is tax money they could make. Instead they require you to pay pro rata on the amount you convert.
Let’s take an example very near and dear to my heart (so I can finally understand what sort of tax liability I’m looking at here.)
I would like to convert my current IRAs to Roth IRAs before rolling over my high-fee 401k (*or I need to get a new job with a better 401k as I can rollover my 401k to that so I can continue to do Roth conversions year after year.)
Vanguard IRA (from rollover 401k)
$26,987 (all pre-tax)
$14,027.47 ($10k is post-tax, $4027.47 is pre-tax)
Due to the pro-rata rule it is not possible for me to rollover just the $10k of post-tax money today.
If I rollover the $10,000 of post-tax money, the pro-rata rule would take my total amount of IRA money $41014.47 to determine how much I actually owe.
To figure this out for yourself, follow the steps listed here.
1. Total up all of your IRAs (non Roth): $41,014.47
2. Total up all of your after-tax dollars in IRAs: $10000
3. Calculate your % of after-tax dollars: 24.38%
4. Determine the taxable amount of your distribution: ($20,000 distributed = $4876 tax free, $15124 taxable(!))
5. Exception for rollovers to a company plan: n/a
In order to take out the full $10,000 of post-tax money, I’d have to convert the entire amount ($41,014.47) and pay taxes on $31,014.47.
Is either scenario worth it? Let’s play this out to the conclusions…
- 35 years growth
- .05% average interest rate
- 30% federal and 10% state tax in retirement (40% taxes)
1. I do nothing, and leave my $41,014.47 to grow for 35 years until I turn 65 and retire.
- $226,235 pre-tax
- Total Value = $135,741 (@40% tax bracket)
- ((15% tax bracket, in 0% income tax state, low annual withdrawals, would = $192,229))
2. I convert 25% of my IRA plans today
- Pay tax on $15,124 at today’s tax rates (28% fed, 10% state – $5747.12 in tax)
- Have $14252.88 remaining to grow tax free forever
- $78,619 post-tax on conversion
- + $116068 * 40% tax = $69640
- Total Value = $148,260
3. Just for kicks, I convert 100% of my IRA today, paying tax on $31,014.47
- Pay tax on $31,014.47 at 38% rate — $11785.50 in tax paid today
- $29228.97 remaining to growth tax free forever
- Total Value = $161,227
4. Additional test thrown in — low income year, 25% tax today
- Pay tax on $31,014.47 at 25% rate — $7753.61
- $33260.86 remaining to grow tax free forever
- Total Value = $183,467
What do these calculations teach us?
- The value of a Roth Conversion (if you have both deductible and non-deductible IRAs) is determined largely by your current tax rate and your expected tax rate in retirement (oh fun, guessing games.) Apparently people tend to overestimate how much taxes they will pay in retirement (i.e. maybe my 40% estimate is too high. You think?)
- The conversion for an account that looks like mine MAY make sense if I can hold it for 35 years or longer. But it’s still not a sure bet. (I calculated everything at a 5% return YoY to be conservative.)
When Does the Roth Conversion Not Make Sense?
I haven’t done all of the calculations, but I assume at some age the roth conversions do not make sense UNLESS you have no taxable money to deal with. If you don’t have many years for the interest to compound and make up for what you paid in tax, then you’ve just paid a lot of money to the government to make less in the end. That’s what they want you to do. That’s what a lot of people who aren’t running the numbers are going to do thanks to this new rule.
When Does the Roth Conversion Make a Lot of Sense?
If you have one year of your life where you happen to not be making a lot of money — maybe it’s a year you went to school or took time off to have a kid — you will be able to do the conversion and pay your income tax on that conversion. If you are single and have no income, your first $36,900 of taxable conversion (or mix of conversion amount and income) is taxed at just 15% (the first $9600 at 10%.) This changes the numbers quite a bit! So say you want to convert $20k with $10k of it non taxable and $10k taxable. You pay $1k on the first $9600 and 15% on the $400 ($60) so you’d pay just $1060 to convert your $20k, leaving you with $18940 to grow tax free forever — if you live in a no income tax state, anyway (most states will charge you income tax so factor this into your calculations as well.) That’s still a pretty great deal, but you’re also losing all of the money you could have made that year and put into your investment accounts, so it’s not worth it to do this unless you are already planning to take the time off. (And if you really want to be tricky move to a state with no income tax and don’t work for a year!)
(Note, married couples can stay in the 15% tax bracket up to $73,800 income including the taxable IRA conversion amount.)
The Best Trick I’ve Found (That is legal, at least for now)
If you have a work-sponsored 401k, find out if it allows you to “reverse rollover” pre-tax IRA investments. If you can do this, take all of your pre-tax IRA investments and move them into your 401k. You will have to keep those investments in the 401k until you change jobs again (and at least for a year) so if the 401k offers crappy, high-fee, high-load mutual funds you’re going to want to run all the numbers in your specific situation. That said, if you have a decent 401k and can rollover your funds into it — you can roll them over and then only pay taxes on your interest on any post-tax IRA contributions for the Roth conversion. This means that you can save a lot of money and do a few years of IRA conversions to grow your roth (esp if you are a high income earner and are already maxing out your 401k.)
Now that I’ve figured out this is do-able, I’ve immediately decided to rollover my existing crap high-fee 401k into my Vanguard low-fee, no-load Admiral funds IRA account. I’ll let those babies grow until I have a nice 401k at a future job (knock on wood) that lets me roll over my IRA for a while, and I’ll convert at least the $14k of traditional IRA investment plus probably another $5.5k for the current plan year. I will have to run the numbers myself at the time but I think this is probably the best idea.
Even if that doesn’t work out, the actual growth on my pre-tax accounts will still be beneficial and perhaps my actual tax rate in retirement won’t be quite as high as I think it will be. It still might be best just to leave these accounts alone and continue putting $5.5k in a Roth every year that I’m eligible, whether I’m in school and working part-time or unemployed and unexpectedly coming in within the income limits to contribute to a Roth.
Have anything else to add? Think I don’t explain this well?
Leave a comment with your tips and ideas for when a Roth IRA conversion makes sense, and when it doesn’t. Did I get something wrong here? Let me know. Thanks!