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Effect of Tax Rates on Roth IRA Conversion
Without loss of generality, let's assume equal growth in assets for the Roth and Traditional IRA accounts for the same time period for each of the three situations illustrated below. The only changing variable is the tax rate in the conversion and the withdrawal years.
Situation A
The tax rate in the conversion year equals the tax rate in the withdrawal year. Conclusion: When tax rates remain the same, conversion to a Roth IRA provides no advantages over keeping a Traditional IRA.
|
|
Traditional |
Roth |
| Tax Rate in Conversion Year |
n/a |
25% |
| Tax Rate in Withdrawal Year |
25% |
n/a |
| Pre-Tax Balance |
$10,000 |
$10,000 |
| Tax on Conversion |
$0 |
$2,500 |
| Balance after Conversion |
$10,000 |
$7,500 |
| Withdrawal Amount |
$15,000 |
$11,250 |
| Income Tax On Withdrawal |
$3,750 |
$0 |
| Balance |
$11,250 |
$11,250 |
Situation B
The tax rate in the conversion year is greater than the tax rate in the withdrawal year. Conclusion: When the expected tax rates increase in the conversion year, keeping the Traditional IRA and forgoing the Roth Conversion is the best outcome.
|
|
Traditional |
Roth |
| Tax Rate in Conversion Year |
n/a |
30% |
| Tax Rate in Withdrawal Year |
20% |
n/a |
| Pre-Tax Balance |
$10,000 |
$10,000 |
| Tax on Conversion |
$0 |
$3,000 |
| Balance after Conversion |
$10,000 |
$7,000 |
| Withdrawal Amount |
$15,000 |
$10,500 |
| Income Tax On Withdrawal |
$3,000 |
$0 |
| Balance |
$12,000 |
$10,500 |
Situation C
The tax rate in the conversion year is less than the tax rate in the withdrawal year. Conclusion: When the expected tax rates decrease in the conversion year, converting to a Roth IRA is the best outcome.
|
|
Traditional |
Roth |
| Tax Rate in Conversion Year |
n/a |
20% |
| Tax Rate in Withdrawal Year |
30% |
n/a |
| Pre-Tax Balance |
$10,000 |
$10,000 |
| Tax on Conversion |
$0 |
$2,000 |
| Balance after Conversion |
$10,000 |
$8,000 |
| Withdrawal Amount |
$15,000 |
$12,000 |
| Income Tax On Withdrawal |
$4,500 |
$0 |
| Balance |
$10500 |
$12,000 |
Source: TIAA-CREF Institute, September 2009
Additional Roth Articles:
Roth IRA Calculators -- Comparing Roth/401k/IRA Conversion & Contributions
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