Many Roth conversions that look good on paper are in fact losing propositions. That’s the implication of an article published in the September issue of the Journal of Financial Planning. Entitled “Net Present Value Analysis of Roth Conversions,” the article was written by Edward McQuarrie, professor emeritus at the Leavey School of Business at Santa Clara (Calif.) University.
A Roth conversion transfers money from your tax-deferred account —401(k) or traditional IRA — into a Roth IRA, paying the tax on the amount transferred all at once. Since future withdrawals from your Roth IRA incur no tax, unlike the required minimum distributions (RMDs) from a 401(k) or traditional IRA, the traditional financial planning advice is to do this conversion if you believe your future tax rates will be higher than they are at the time of conversion.
McQuarrie doesn’t disagree with that rationale, but points out just how long it will take for those tax savings to be booked. Because the tax savings of a Roth accrue over many years, it’s important to analyze those savings in constant dollars.
McQuarrie’s article conducted just such a net present value analysis, using the rate of appreciation on the portfolio to discount future tax savings. To illustrate what he found, consider a hypothetical 72-year old who undertakes a $100,000 conversion, paying the 22% tax that would be due per current IRS tax brackets.
If he didn’t do the conversion and left his money in his 401(k) or traditional IRA, he would instead pay a 25% tax on each of the RMDs he would receive in subsequent years (this is assuming the expiration of the 2017 tax cuts).
Paying a 22% tax instead of a 25% tax would seem to be a no-brainer. And indeed there is a payoff. But a 3% less tax on each year’s RMD takes a long time to add up, according to McQuarrie. To show this, he constructed a ledger that, for each subsequent year, showed the total tax payments made up to that year as well as the total tax savings realized by then—all in constant dollars. The chart below details what he found:
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As you can see from the chart, it takes many years for the conversion to pay off. That’s because the taxes from a Roth conversion are incurred up front, while the tax savings accrue gradually year by year in increasingly deflated dollars.
McQuarrie calculates that, in constant dollars, this retiree’s total tax savings from the conversion most likely will not exceed his upfront payment until after he has died. In fact, assuming this retiree dies at his life expectancy, his cumulative tax savings at death will be about $7,000 less than his upfront bill by taking the Roth conversion at age 72.
In that case, the benefits of the Roth conversion will only be enjoyed by this individual’s heirs, who if the conversion hadn’t taken place would have had 10 years after death to continue taking RMDs. Only when 26 years have passed since the Roth conversion, when the retiree would have been 97, will the cumulative tax savings exceed the upfront tax bill, in constant dollar terms.
McQuarrie is quick to acknowledge that it’s possible to construct other hypothetical examples in which the Roth conversion has a much quicker payoff. If the conversion can take place at a tax rate in the single digits, for example, and subsequent years’ RMDs would have incurred a much higher double-digit tax rate, then the risk-reward calculus shifts significantly in favor of converting.
Even then, the payoff from a conversion is uncertain. Imagine a near-retiree who took a Roth conversion at a 22% rate, in the expectation that the 2017 tax cuts would expire in 2026, when the U.S. federal tax rate for his bracket is slated to revert to 25%. But with Donald Trump the U.S. president-elect and Republicans set to take control of both houses of Congress, it’s likely that the 2017 tax cuts will be extended, and this original rationale for a Roth conversion will evaporate.
Changes to the tax code are just one source of uncertainty in whether the Roth conversion pays off. Another is how long you live, and the tax rate your heirs would incur in the 10 years after your death in which they would otherwise have been able to continue taking RMDs. Even without these sources of uncertainty, it’ll be many years before the Roth has a positive payoff.
McQuarrie analogizes a Roth conversion to a 20- or 30-year loan you extend to the federal government, with the interest it pays on your loan dependent on subsequent changes that may be made to the tax code and no guarantee that the loan will ever be paid off. Put that way, Roth conversions certainly seem a lot less compelling.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at
