The math behind converting from a Traditional IRA to a Roth IRA

A lot of people ask if it makes sense to contribute and/or convert to a Roth IRA. If you have money in a traditional IRA and want to convert it to a Roth (either all or part) you have to pay income taxes (but not any penalty) on the amount you convert. The big question is: Does this make sense financially for me?

Here is an example: You have $10,000 in a traditional IRA. You are considering converting it all to a Roth.

The Numbers: Your total income taxes (Federal, State, Local) come out to be 25% of your income. This means you would have to pay $2,500 total in taxes to do this conversion. This will obviously change if your actual tax rate is higher or lower but I am using this for simpler math.

You also have to look at the back end. For this I will assume an 8% annual rate of return and the same 25% tax rate. Let's say you withdraw the money from the IRA account after 20 years.

If you leave it in the traditional IRA: $46,609.57 - $11,652.39 = $34,957.18.

If you convert the assets to a Roth IRA: $46,609.57 tax free! (you save $9,152.39 in tax by paying the taxes now).

This is a very simplified example but if you were to withdraw $46,000 for 1 year of retired life expenses you come out way ahead in the case of the Roth. If your tax rate is lower you still come out ahead but not as much. The general rule is to go with Roth if at all possible. Especially if you have a long time to invest the money before taking it out.

The only scenario where this doesn't make sense is when you have a high tax rate now. If you expect your taxes to be significantly lower during retirement it may make sense to leave it in a traditional IRA. Secondly if your income is too high you may not be eligible to convert it to a Roth IRA. A tax specialist can shed more light on this specific case.

The bottom line is that unless you are a very high wage earner you should go with the Roth IRA. This is one of the few truly tax free accounts that we can take advantage of. Time is on your side if you use it wisely! Run your own numbers and see how much you can come out ahead!