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!

Heads up! SIMPLE IRA is not simple!

My employer provides a SIMPLE (Savings Incentive Match Plan for Employees) IRA retirement plan and I am starting to learn a lot about the rules and regulations. It got the name "SIMPLE" because it is easy for an employer to administer. However, it can be a bit complicated for the owner of the account as I have found.

Here are some major differences between a SIMPLE and Traditional IRA Accout:

• Contribution limits. You can put up to $11,500 (age 49 & under) in tax year 2009 versus only $5,000 (age 49 & under) in a Traditional IRA.
• Time: 2 years is the magic number for a SIMPLE IRA. If you take an early withdrawal (that is not qualified) within the first 2 years of having the account you get nailed with a 25% penalty PLUS normal income taxes. Ouch! Traditional IRA is 10% penalty no matter how old the account is.
• You get employer matching in a SIMPLE IRA account much like a 401(k) plan. There is no vesting period so the money is yours on Day 1. The matching is mandatory under IRS rules.

Most everything else is essentially the same as a Traditional IRA. The contributions are from before tax dollars. You can invest in anything the broker holdling the account offers. After the 2 year period is over you can convert to a Roth IRA if you wish. This is good for younger people as the tax payoff over the long term can be huge.