Vanguard’s “BETR” Approach to Roth ConversionsSubmitted by Fiduciary Financial Advisors - Clarity Capital Advisors on February 28th, 2019
A recent paper from Vanguard sheds light on when it makes sense to transfer funds from a traditional IRA to a Roth IRA (a Roth conversion). Recall that the proceeds of a Roth conversion are subject to taxation at the investor’s marginal rate, but the converted funds are tax-free forever (i.e., until the account is depleted either by the investor or his heirs).
A commonly used approach is to compare the investor’s current tax rate to his anticipated future tax rate, and if the future rate exceeds current rate, then proceed with the conversion. Otherwise, leave things as they are. As with most simple investing rules of thumb, this one is flawed, as it innately assumes that the taxes are paid out of the converted funds and fails to account for the possibility that the taxes can be paid out of a separate taxable account. Vanguard’s break-even tax rate (BETR) approach shows how the future tax rate can be lower than the current tax rate, yet a Roth conversion remains the preferred course of action
Let’s look at a simple example: Joe has $10,000 in a traditional IRA and is in the 35% tax bracket. If he converts the $10,000, Uncle Sam will come looking for his $3,500. If Joe pays it out of the converted funds, he will now have $6,500 in the Roth. If his future tax rate is lower than 35%, then Joe is worse off.
Suppose instead that Joe paid the $3,500 tax bill from a taxable account without incurring significant capital gains. What he has effectively done is to move the $3,500 from a taxable account to a Roth IRA, as the Roth IRA will now have $10,000 rather than $6,500. Now our question becomes whether Joe is better off with $10,000 in a traditional IRA plus $3,500 in a taxable account or $10,000 in a Roth IRA? Under a reasonable set of assumptions regarding future returns and taxes on capital gains and dividends, the BETR is below 30%. In the case where the taxable funds would have remained in a tax-inefficient portfolio, the BETR drops below 24%.
Roth conversions are especially important for investors who earn too much to contribute to a Roth IRA. Once their traditional IRAs are cleared via taxable Roth conversions, they can execute backdoor Roth conversions, which are done by making a nondeductible contribution to a traditional IRA followed by a nontaxable Roth conversion. Lastly, the BETR approach also applies to the decision of whether to make a pre-tax or a Roth 401(k) contribution, providing that the investor has taxable funds to pay the higher taxes that will result from electing the Roth option.
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