Deciding between a traditional individual retirement account (IRA) and a Roth IRA can be difficult. Choosing when or if you should convert your IRA funds to a Roth account can be even more daunting. Experts commonly recommend that investors compare their current and future marginal tax rates to decide, but future tax rates can be highly uncertain and many investors are left wondering whether they made the right choice. Now, investment giant Vanguard has a more precise answer. Here’s how calculating your break-even point can pinpoint whether a Roth conversion makes sense for you. A financial advisor could help you save for retirement and select investments that align with your financial goals. Find a qualified advisor today.
Vanguard Finds the Ideal Tipping Point for a Roth Conversion
Typically the rule of thumb is that Roth IRAs are most beneficial if an investor expects to be in a higher tax bracket upon retirement, since Roth contributions are taxed at the current rate and distributions are tax free. As such, Vanguard experts say that “assessing the current tax rate and expected future tax rate is a good first step” in determining whether you should convert your retirement savings to a Roth account.
However, sometimes a Roth conversion can be beneficial even if your future tax rate declines instead of increasing. So rather than a straightforward tax rate comparison, the firm recommends conducting a dynamic Break-Even Tax Rate (BETR) analysis to determine if a conversion is right for you. Calculating a BETR offers investors an approach that simplifies the decision-making process.
“If your future tax rate is at the BETR, conversion wouldn’t make a difference,” Vanguard analysts explain. “Simply put, the BETR shows how far your tax rate would have to fall to make conversion undesirable.”
If an investor’s future tax rate is higher than a calculated BETR, generally a Roth conversion would make sense financially. Even if an investor’s future marginal tax rate is lower than it is currently, certain scenarios can lower a BETR and make a conversion far more attractive than it would otherwise seem in a straightforward rate comparison. This could potentially save an investor thousands of dollars.
For instance, if you’re able to pay Roth conversion taxes from a taxable account, such as your standard brokerage account, the full value of your IRA can move to the Roth account. By not paying the conversion taxes from the IRA but with other portfolio funds, you can lower your BETR substantially. Vanguard calculates that, if an investor pays a current 35% marginal tax rate and expects to pay the same in retirement, converting to a Roth and paying taxes from a tax-efficient portfolio could lower the BETR to 29.6%. If taxes were paid from a tax-inefficient portfolio, where the investor has to pay annual taxes on investment returns, the BETR falls even further to 23.5%. As a result, a Roth conversion suddenly becomes rather appealing.
