[As with anything tax-related, see my disclaimers.]
The other day at work, I was discussing the advantages of converting traditional IRA money into a Roth IRA with a coworker. I’ve always been of the opinion that if my marginal rate is the same today as in the future when I withdraw the money, then it makes no difference to convert today instead of waiting until the future. However, my coworker had a different set of assumptions that made me reconsider my position.
Six one way, half a dozen another
To explain why it makes no difference, take the following hypothetical example. I have $6,000 (my contribution limit in 2020) that I want to put into either a traditional IRA or a Roth IRA. My marginal tax rate is 24% now and in the future. My traditional contribution is fully deductible, so I pay no tax on the contribution today but will in the future at my marginal rate. Further, I assume a 7% annual rate of return and plan on withdrawing/converting everything in 30 years when I’m age 60.
Scenario 1: I contribute to the traditional IRA, opting to pay tax in the distant future. The contribution grows to $42,685. At withdrawal, I pay $10,244 in tax, and I am left with $32,441.
Scenario 2: I contribute instead to the Roth IRA, paying $1,440 in tax today and investing the remainder. After 30 years the Roth IRA’s value is…wait for it…$32,441, exactly the same as the traditional IRA.
I paid more tax in scenario 1 than I did in scenario 2. However, what I kept in the end was the same. I can pretend that Uncle Sam let me hold on to his money for a longer period, piggybacking off my awesome investing prowess.
Tax Money Assumption
One assumption to test is how the original taxes on the Roth contribution is paid. If I had an additional $1,440 kicking around, I could use that to pay the taxes and have the full contribution working through the years. This gives the advantage to the Roth because it has a full $6,000 to invest but no future tax.
Not so fast. To make an apples-to-apples comparison, the $1,440 needs to be applied to both scenarios. In the traditional IRA contribution scenario, I place the extra $1,440 into a taxable account that grows at the same annual rate as IRA monies. I strive for tax efficiency, only realizing a capital gains rate of 15%. The Roth will now be “behind” right up to the point when taxes on the traditional IRA are realized, at which point the Roth “leaps” ahead. Or the traditional IRA “jumps” behind, if you like.
Even the relatively small capital gains tax dragged me down over the long haul. I may try to increase my tax efficiency by only selling funds in the taxable account at the very end of the period, realizing capital gains tax once instead of every year, but I likely won’t avoid reaping taxable dividends along that way and I’d still be behind some amount. Additionally, a tax-loss harvesting strategy could further reduce the drag, but it will be hard to get that tax drag to zero.
Assuming my tax rates are the same now and at withdrawal, I may be better off making a Roth contribution or a Roth rollover today if I can pay the taxes with other monies. I personally have a mix of traditional and Roth funds, reducing the risk of either higher or lower taxes.
The core assumption that tax rates won’t change is surely wrong. I’m not sure anyone can reliably predict what the rates will be in the future. I have seen them change multiple times in the last 15 years. I personally lean towards putting off rollovers and Roth contributions until I’ve fully funded all my pre-tax accounts. But that’s because I’ve already run the numbers to determine how much is too much in my pre-tax accounts.
- Taxable because $6,000 was the max I could contribute to taxable accounts.
- We can already “predict” past tax rates