Don't Use An Internet Calculator To Figure A Roth Conversion

Many financial services firms offer a calculator on their website to help you decide on a Roth conversion. You would think that they would at least be accurate, but you would be wrong. They leave out an important factor in the calculation, resulting in a bias towards the Roth.

The problem with Internet calculators is that they do not live in the real world. Only when you take into account ALL the needed variables can you have a real-world comparison to determine if converting to a Roth IRA makes sense.

The single most important thing to remember when making a Roth conversion is that you need to pay the taxes with money outside of the IRA you are converting from. If you didn’t convert to a Roth, that money would continue to grow.

Here's where the Internet calculators are deficient.

If you do NOT convert to a Roth, the money in your traditional IRA will continue to grow and the money you didn't spend out of 'other funds' to pay the conversion taxes would also still be growing. To create a real-world comparison, we must include the use of a 'side fund' to include this 'other' money.

Therefore, the real-world comparison MUST allow the money in the 'side fund' to grow (with dividend and capital gains taxes just like the real world); and that 'side fund' account must be added to the taxable IRA distributions used as a comparison to what could be removed from the Roth IRA (if you did choose to convert and pay the taxes out of 'other' money).

The Internet calculators do not include this 'side fund'. This is important to understand so let me walk you through an example, and you'll see why you need to account for this.

If you convert a $500,000 IRA to a Roth and you are in the 35% income tax bracket with all of the converted money, there would be a tax due of $175,000. By using 'other' money to pay the tax, $500,000 is allowed to stay in the Roth and grow tax-free. All of the money, $500,000 plus any growth, will be able to come out tax-free in retirement.

Let's first assume you have $175,000 sitting around in cash to pay the taxes. That's great; but when running a comparison to make sure the conversion made sense in the first place, you have to assume the $175,000 would have remained invested (this is what I call the 'side-fund').

Then, when you get into retirement, the comparison is how much could be removed from the Roth IRA after tax vs. how much could be removed from the taxable IRA AND the 'side fund.'

Now let's assume you have to sell low-basis stock to pay the income taxes on an IRA conversion. Let's assume that the basis in the stock is $75,000. That means that $100,000 of the stocks sold to pay the income taxes at conversion is subject to capital gains tax.. If we assume all of the stock sold is at the long-term capital gains tax rate (15%), there would be a tax due of $15,000. If that tax is paid, then you do not have $175,000 to pay the income taxes on the money coming from the IRA (there is a $15,000 shortfall).

Therefore, you need to sell more stock, which also incurs a capital gains tax. In this example, you actually have to sell an additional $17,647 worth of stock to end up with $175,000 cash to pay the taxes due on the IRA conversion.

Therefore, the 'side fund' needs to be funded not with $175,000 but with $192,647. Again, this information is usually omitted from online calculators and is a huge flaw.

The end result of using an Internet calculator is that it undervalues the tradtional IRA by the value of the side fund, thus skewing the result towards a Roth conversion. In general, remember this:

(1) If you have to use money from the IRA to pay the taxes, a conversion will leave you worse off.

(2) Even if you do have other money available for the taxes, a conversion only works in certain situations, typically for a younger person, or if you assume your future tax rate is higher.

So if your main reason for considering a conversion is thinking you will have a more valuable account, let me check to make sure this strategy will actually work for you. Call 408-725-7135 for a one-hour appointment to analyse your situation using software that provides 'real world' results.

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