Concerning the Death of the Stretch IRA, are Roth IRA conversions right for you?
This post is the tenth in a series about the Death of the Stretch IRA. It discusses how Roth IRA conversions work, and how they might be able to benefit your family under the current law. It also explains how Roth IRA conversions might be beneficial to your family if the Stretch IRA is eliminated.
How Roth IRA Conversions Work
Before we get into the benefits, I want to explain the process of how Roth IRA conversions work. In order to do a Roth IRA conversion, you take money that you have in a traditional tax-deferred IRA account and transfer it to a tax-free Roth IRA account. There’s paperwork that your IRA custodian has to file so that the IRS knows to expect some tax money from you.
When you contributed to that traditional IRA, you probably received a tax deduction for it. The IRS obviously won’t let you take a tax deduction for the contribution that you made to your traditional IRA and then get your future earnings tax-free too. So when you do a conversion, you have to pay tax on the amount that you transfer out of your traditional IRA. The benefit to converting, rather than simply withdrawing the money and putting it in a standard brokerage account, is that the future gains on the earnings will be tax-free. But is it worth it to convert?
Roth IRA Conversions and Purchasing Power
In my opinion, the key to understanding the benefits of Roth conversions is to understand the concept of purchasing power. So let’s look at an example. You have $100,000 traditional IRA plus $25,000 non-IRA money – for a total of $125,000. I have $100,000 in a Roth IRA. Even though I have less money than you, I will argue that we have the same amount of purchasing power. Here’s why.
Let’s say you want to buy a boat – better yet, a really big boat. In order to get the money to pay for it, you have to cash in your $100,000 IRA. Since it’s a traditional IRA, you’ll be required to pay taxes on your withdrawal. If you’re in a 25% tax bracket, you’ll also be required to liquidate your $25,000 non-IRA account to pay the tax due. Now let’s say that I want to buy the same boat. I cash in my $100,000 Roth IRA, but I don’t have to have to send money to the IRS for a tax payment like you did. So even though your account balances were higher than mine when we started, you had to spend more money than I did to buy the same boat. Because my money was in a tax-free account and yours wasn’t, I had the exact same amount of purchasing power that you did, from the very start.
Is it Worth it to Convert Your Traditional IRA to a Roth?
But is it worth it to pay taxes that you don’t owe right now, just to end up in a tie? It’s a great question. For many people, it IS worth it. I cover Roth conversions in great detail in Chapter 7 of my book, Retire Secure! One point that I make in the book is that it is very important to actually “run the numbers” to see if it will be advantageous for you to go through the process yourself. And while there are several online calculators that claim to demonstrate the value of Roth conversions, the truth is that the process is just not as simple as they make it out to be. The reasons for this are too complicated to get into on this blog, but you can read about them in my book. The book demonstrates several scenarios where Roth conversions can save families a significant amount of money, and also somewhere it was a bad idea.
Roth Conversions and the Death of the Stretch IRA
Roth conversions can be a very effective solution for many individuals who have large IRAs. When the Death of the Stretch IRA legislation is finalized, they may become even more important. Stop back soon to learn why.
For more information on this topic, please visit our Death of the Stretch IRA resource.
P.S. Did you miss a video blog post? Here are the past video blog posts in this video series.