Volume 15, Issue 1
37
Roth Conversion: An Analysis Using Breakeven Tax Rates, Breakeven Periods, and Random Returns
V. Sivarama Krishnan, Associate Professor of Finance, University of Central Oklahoma Julie Cumbie, Assistant Professor of Finance, University of Central Oklahoma
Abstract The Roth IRA, created in 1998, denied access to high-income individuals. Tax law changes that were enacted in 2005 and later have made the benefits of a Roth IRA available to nearly everyone regardless of income levels through possible conversions of deductible/non-deductible IRAs. This paper develops a multi-dimensional decision framework. The framework includes a metric to compare to the expected marginal tax rate at withdrawal of funds, as well as, the minimum investment horizon needed to breakeven in terms of expected after-tax future values of the alternatives. Also, we analyze the impact of random variability in the expected returns on these metrics. Roth Conversion would benefit investors with long investment horizons and those who do not expect any significant reduction in their marginal tax rates. Possible tax law changes represent the greatest uncertainty for anyone considering conversion.
Introduction Tax law changes in recent years have made more investment choices available for retirement. One of the more significant changes includes the provision made in 2010, which brought a Roth IRA within reach of everyone regardless of income. While contributions to a Roth IRA are still subject to income limits, anyone can now convert his/her traditional, tax deductible IRA or non-deductible IRA to a Roth IRA. The conversion would, of course, attract immediate taxation of the converted IRA amount. This paper analyzes the conversion decision by looking at the tax implications, the after-tax future values and the advantageous features available to a Roth IRA. The conversion decision is usually analyzed by financial planners and advisors as a trade-off between paying tax now on the converted amount against future tax savings on all withdrawals from the IRA. This approach involves computing the after-tax future value of the investment dollars for the two options. The choice though, is far from simple or obvious because of the number of factors involved in the trade-off and the uncertainties surrounding them. This paper analyzes the conversion decision using the framework developed by Krishnan and Lawrence (2001) and Horan and Peterson (2001).