Can the Moderate-Income Gain from Converting to a Roth?

In 2010 everyone, regardless of income, will be eligible to convert their regular IRA money into Roth IRAs. Doing so will require paying taxes on the amount converted; i.e., the amount taken out of the regular IRA and put into a Roth IRA.

We've already published one case study that showed a couple converting 300K to a ROTH and raising their lifetime living standard 2.45% (i.e., every year they spend 2.45% more for the rest of their lives). That's a tremendous incentive to do the conversion if you have the resources to pay the tax bill. But how do the numbers work with a couple with more modest earnings, which makes a smaller, in this case, $50K, conversion.

Well, let's find out.

This case study shows a .6% annual gain ($443) in living standard from exercising this option.

The couple’s annual living standard (discretionary spending, which we call consumption, adjusted for economies in shared living) and taxes. By converting to the Roth, the couple raises their living standard by .59 percent from $75,103 to $75,546 ($443) for each year of their lives from age 54 through age 100.

The extra tax burden in 2010 is $16,629. Where do Tom and Janet get this extra money? Remember, ESPlanner is using "consumption smoothing" and their discretionary spending or "consumption" remains a steady $75,546 in 2009, 2010, 2011, and beyond. The program realizes they have this extra tax burden in 2010 and thus has them set aside much less in regular assets that year to cover this extra tax.

What explains this gain? After all, conventional wisdom is that it deferring taxes is the tax-savvy thing to do. The explanation is that by bunching a good part of their taxable income into a single year, Tom and Janet are able to dramatically limit the taxation of their Social Security benefits as well as lower their marginal tax brackets in future years, particularly very late in life when they withdraw from their Roth accounts.

To be more precise, when they don't convert Tom and Janet land, late in life, in the 85 percent bracket with respect to paying taxes on their Social Security benefits; i.e., every extra dollar of adjusted gross income means that Tom and Janet will pay taxes not just on that extra dollar, but also an extra 85 cents of Social Security benefits. Stated differently, every dollar more (less)of adjusted gross income raises(lowers) Tom's and Janet's taxable income by $1.85.

Hence, there is a very big tax-saving bonus to Tom and Janet from reducing their adjusted gross income in old age. But this is precisely what happens when they convert to a Roth. The withdrawals from the Roth late in life are not included as part of their adjusted gross income. So in paying a lot more taxes in 2010, Tom and Janet get to pay a lot less in taxes late in life.

The reason that Social Security benefit taxation becomes so pernicious to Tom and Janet late in life is that the income (calculated basically as AGI plus half of Social Security benefit) thresholds beyond which first 50 percent and then 85 percent of their Social Security benefits become subject to taxation are not, themselves, indexed to inflation. These Social Security thresholds as well as the threshold beyond which households are subjected to the Alternative Minimum Tax are the most noticably unindexed features of the U.S. tax code.

In addition to reducing Social Security benefit taxation, converting to the Roth lowers the couple's federal income tax bracket late in life from 25 percent to 10 percent. Finally, the converstion moves the couple from the 85 percent to the 50 percent marginal Soical Security benefit taxation bracket.

There is some follow up discussion and a bit more detail on this case study in our forum. Click here to read it.