By A. B. Jacobs
In past articles I’ve compared the relative benefits of traditional IRAs with those of Roth IRAs. Despite an inability to deduct contributions, I invariably advocate Roth for most qualifying persons. This is due to its fully tax-free treatment as opposed to the merely tax-deferred character of a traditional. This benefit can even make it advantageous to convert a traditional into a Roth, and on occasions I’ve advocated this maneuver. However, doing so must not be done without weighing the consequences, and this means number crunching. Let’s take a closer look at the possibilities.
Consider a 30-year-old unmarried resident of Florida with annual taxable income of $50,000 and a traditional IRA valued at $100,000. If we presume those assets compound at 7½% per annum (a reasonable expectation), they will grow tax-deferred over the next 35 years until anticipated retirement to become $1.25 million. By contrast, we might roll the assets into a Roth IRA, which will grow to a like sum over the years, though doing so triggers its being taxed initially as ordinary income which, superimposed on the other earnings, calculates to a tax payment of $27,350. If paid with money from outside the account so to avoid penalties, it means liquidating personal assets. Had those funds not been so dissipated, they would have compounded over 35 years at an after-tax rate of about 5½% to become $178,000.
At this point we’ll compare the two retirement cash flows: income on $1,250,000 from the Roth IRA or that from $1,428,000—$1.25 million in the traditional IRA plus $178,000 personal assets. Presuming that each can generate 7½%, the respective annual cash flows are $93,750 tax-free versus $107,100 taxable. Although the comparative advantage of tax-free versus taxable income 35 years into the future is not easily predicted, it’s unlikely the citizens’ burden will by then have eased. It’s plausible to expect that, in the great bountiful society of the future, six-figure income will be taxed at no less than 25%. In that case, the annual net cash-in-pocket upon retirement will be $93,750 from the Roth rollover as against $80,325 by abstaining. It’s quite clear that the Roth rollover is a benefit in this case.
We’ll now modify our example just a little: Our Florida resident becomes a Californian, and in doing so consumes all disposable cash outside the IRA account. Over 35 years the traditional IRA will experience no change; it will still grow to $1.25 million. But conversion becomes more expensive for two reasons: a 9.3% state income tax as opposed to no tax in Florida, and penalties for withdrawal of IRA funds to pay these taxes—10% to the federal government plus 2.5% to California for any amount liquidated. The governments thus receive jointly $41,885 ($36,650 taxes and $5,235 penalties), resulting in a Roth IRA balance starting at $58,115. At 7½% annually over 35 years, it grows to $730,400. Our comparative retirement cash flows now become $43,590 tax-free from the Roth versus $93,750 taxable from the traditional. It’s clear that unless tax rates ultimately become near-confiscatory, the Roth rollover does not pay for itself.
You now possess a blueprint by which to analyze whether or not conversion from a traditional to a Roth IRA makes economic sense. Variables that affect your calculations will be amount of IRA assets converted, individual’s age upon conversion, anticipated age at retirement, state tax and penalty rates, and source of funds from which the conversion tax will be paid. In general, prospects for conversion are most promising with a lesser amount of assets, greater time span between conversion and retirement, low state income tax rate, and sufficient available cash to avoid dipping into IRA assets for the tax payment. As a rule of thumb, conversions seem to make sense for persons under age 35, in states with low income tax rates—or better yet, none, such as Florida, Texas, Nevada, and a few others—and when the amount to be rolled is relatively small. However, under all circumstances, I strongly advocate that you actually grind out your numbers before you commit.
Before we depart this subject, and while our brains are still in gear, there’s a matter that warrants consideration. If you’re one of the unlucky ones for whom rollover is not practicable, is there anything you might do to improve your situation, perhaps down the line? Let’s look back to the example of our California resident who will retain the traditional IRA, possibly adding contributions to it over the years. At retirement, assets might well exceed $1.5 million and generate substantial retirement income—fully taxable, of course. When the day arrives that a California-generated salary is no longer needed, a question comes immediately to mind: If, following retirement, one moves from a state that collects income tax to one that does not, must taxes be paid to that state in which the contributions originated? Although some state tax collectors issue proclamations implying otherwise, it’s my belief that the answer is no. If the new state of residence is one with no income tax, IRA distributions will incur no state taxes regardless of where the IRA assets were amassed.
Regarding state IRA taxation, I’ll conclude with a final caution. If, as a long-time Californian, you claim Nevada residence by using a friend’s address in Laughlin while continuing to occupy your home in Long Beach, you probably won’t get away with it. If tax avoidance is sufficiently important, you’d better do it for real. This means you actually take up full-time residence in the new state, register to vote there, get your driver’s license and auto plates there, take your mail there, and conduct your life as a citizen of the new state. If you try to arrange it by charade, you’re likely to end up with the worst of both worlds: the inconvenience of an illusory change of address together with full taxation of your IRA distributions.
AL JACOBS has been a professional investor for nearly four decades. His business experience ranges from real estate, mortgage, and securities investment to appraisal, civil engineering, and the operation of a private trust company. In addition to managing his investments on a day-to-day basis, he is a featured financial columnist for both online and print publications. He is the author of Nobody’s Fool: A Skeptic’s Guide to Prosperity. You may subscribe to his financial Newsletter, "On the Money Trail," at no cost or obligation, by visiting www.onthemoneytrail.com.
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