How Age and Tax Rate Affect the Roth Decision

In a few recent posts, I have talked about the long-term benefit of Roth-ifying your retirement funds. But is it a good idea for everyone? Certainly not. It’s hard to assess all the factors and uncertainties that go into the decision. But probably the two most critical factors are Time and Tax Rate: How many years until your retirement? How large will your future income tax rate be compared to your current tax rate?

How do these factors impact the Roth decision? Here’s a little thought experiment. Picture Riley. He’s got $10,000 in a traditional IRA and $10,000 in an ordinary taxable investment account. Should he spend some of the dollars in his taxable account to convert the $10,000 IRA into a $10,000 Roth IRA? That depends on how many years Riley has until he retires and his future tax rate. The chart below shows the benefit (or detriment) of the Roth conversion, as measured by the increase (or decrease) in Riley’s future annual after-tax retirement spending generated by his $20,000.

Riley is currently—during his working years—in the 30% tax bracket. The projections below indicate that he might still enjoy some advantage from Roth-ifying his IRA, although a shrinking one, if he expects to be in a lower tax bracket during his retirement years.

Here are the assumptions that went into the figures in the chart.
• Riley’s current tax rate is 30%, so it costs $3,000 to convert his IRA to a Roth.
• Riley is in the 30% tax bracket during his working years.
• Riley’s IRA (traditional or Roth) earns 6% per year during his working years.
• Riley’s taxable account earns 6% during his working years, but keeps only 4.8% after tax.
• Riley spends his two accounts by amortizing them over a 25-year retirement period.
• Riley’s IRA (traditional or Roth) earns 5% per year during his retirement years (when his investments get more conservative).
• Riley’s taxable account earns a fraction of that 5% after tax. To estimate that percentage, I used the following formula:
5% - (2/3) x Tax Rate x 5%
See February 3’s post for the reasons behind the 2/3 fudge factor.
• Riley's assumed number of remaining working years are shown in the top row of the chart below.
• Riley's assumed tax rate during his retirement years are shown in the left-hand column of the chart below.