The Secret:
Quantifying the Benefit of Roth IRA Conversions
Using the Concept of Purchasing Power

I have been teaching the following concept for 22 years, and despite having taught it to thousands, it remains a general secret that millions would benefit from understanding.

“The Secret” involves determining the most accurate measurement tool for wealth. I am not interested in increasing your total dollars as much as I am interested in increasing your purchasing power.

Critical to evaluating the costs and benefits of Roth conversions is thinking in terms of “purchasing power” vs. “total dollars.” For example, if I have $1 million in my IRA, and you have $900,000 in an after-tax account, measured in total dollars, I have more money than you.

But what if we both want to make a large purchase? I must cash in my IRA and pay the taxes. Let’s assume I’d end up with $760,000 in cash after paying the taxes on the IRA distribution. Unless there are capital gains that need to be paid, there will be no tax consequence when you cash out your $900,000. That means you can purchase $140,000 more goods and services with your $900,000 after-tax dollars than I can with my $1 million IRA. Yes, you can vary the tax rate and assume there are capital gains. and there will be a smaller benefit. But when it comes down to it, IRAs have far less purchasing power than after-tax dollars.

Now, let’s look at Roth conversions in terms of purchasing power. Assume that both of us have $100,000 in our Traditional IRAs and $24,000 outside our IRAs. I will assume a flat income tax rate of 24 %. If I don’t make a Roth IRA conversion, I have $124,000 when measured in “total dollars.” But, if I think of that amount in terms of “purchasing power,” I have $100,000.

Here’s a breakdown of that purchasing power math:

$100,000 IRA dollars + $24,000 non-IRA dollars = $124,000 “total dollars” 

$124,000 “total dollars” – $24,000 non-IRA dollars that I will use to pay the tax due when I cash in the $100,000 IRA = $100,000 in “purchasing power”

Now let’s assume that you start with the same $100,000 in your Traditional IRA and $24,000 outside your IRA, and you execute a Roth conversion of your entire IRA. Because you converted your Traditional IRA (which you haven’t yet paid taxes on) to the Roth IRA, you will have to fork over $24,000 of after-tax dollars to Uncle Sam ($100,000 times 24% tax rate). But, after the conversion, you also have $100,000 measured in both total dollars and purchasing power because there will be no tax due when you cash in your Roth IRA.

The table below shows that, when measured in terms of purchasing power and using simple assumptions, the breakeven point on Roth IRA conversions is Day 1, regardless of your age.

*Non-IRA Funds of $24,000 used to pay taxes on either cashing in the traditional IRA or a Roth IRA conversion.

If this concept is difficult, I urge you to reread this section and take advantage of the offer to get The Roth Revolution, a book that explains it the concept in detail.

Again, I can’t overemphasize the importance of this concept. The failure to understand this concept is one of the reasons why many advisors give clients advice regarding Roth IRA conversions that is completely wrong for them. If your measurement tool is total dollars, then your inevitable conclusion will be that Roth IRA conversions are only good for younger taxpayers who have many years for the tax-free growth to accumulate in their Roth IRA, which will outweigh the money they paid to convert their Traditional IRA to a Roth IRA. But total dollars are the wrong measurement tool.

The next logical analysis is what happens over time comparing two identically situated IRA owners when one makes a Roth conversion or more likely a series of Roth IRA conversions over time to the IRA owner who doesn’t make any Roth conversions.

Of course. it all depends on the assumptions you use, but for most IRA owners, there will be a period in your life that it will make sense to do a Roth IRA conversion or a series of Roth conversions. The difference between getting the Roth conversions right, which ideally includes if, when, and how much to convert versus doing nothing could be tens or even hundreds of thousands of dollars, sometimes a million dollars, over time to you and your family.

Unfortunately, I don’t have space in this column to show the next steps, but I assure you if you look at the book (or books because I have been writing about this for over 20 years) or attend my webinars, you will see that there are great opportunities for many IRA and retirement plan owners to make either one or more likely a series of Roth IRA conversions at some point in their lives.

If you would like to learn more about Roth IRA conversions, please call Alice Davis at 412-521-2732 to request your free copy of our book, The Roth Revolution, Pay Taxes Once and Never Again.