Roth conversions often appear advantageous on paper but can be financially unwise in reality. That’s the core argument of Edward McQuarrie, professor emeritus at the Leavey School of Business at Santa Clara University, in his article “Net Present Value Analysis of Roth Conversions,” published in the Journal of Financial Planning.
A Roth conversion involves transferring funds from a tax-deferred account, such as a 401(k) or traditional IRA, into a Roth IRA. The tax due on the conversion amount is paid upfront. Since Roth IRA withdrawals are tax-free, unlike required minimum distributions (RMDs) from tax-deferred accounts, conventional financial advice suggests converting if future tax rates are expected to be higher.
McQuarrie agrees with the basic logic but highlights how long it can take for tax savings from a Roth conversion to materialize. Because these savings accumulate over decades, analyzing them in constant dollars is crucial.
To explore this, McQuarrie applied a net present value analysis, discounting future tax savings using the portfolio’s expected rate of return. Consider a hypothetical 72-year-old who converts $100,000 from a traditional IRA to a Roth IRA, paying 22% tax upfront based on current tax brackets.
If he kept his funds in a traditional IRA, future RMDs would be taxed at 25%, assuming the expiration of the 2017 tax cuts. Paying 22% instead of 25% seems like an obvious win, but McQuarrie shows it’s not that simple. A 3% annual tax difference takes years to outweigh the upfront tax hit.
McQuarrie constructed a ledger tracking annual tax payments and cumulative tax savings, all adjusted for inflation. His findings reveal that the retiree’s total tax savings likely won’t surpass the upfront tax payment until after his expected death. If the retiree lives to his statistical life expectancy, his cumulative tax savings would still fall about $7,000 short of his upfront tax bill.
The real benefit would only go to his heirs. Without the conversion, they would have 10 years post-death to withdraw from the inherited IRA under current RMD rules. In McQuarrie’s model, it would take 26 years from the conversion date—when the retiree would have been 97—for the cumulative tax savings to finally exceed the initial tax bill in constant dollars.
McQuarrie acknowledges scenarios where a Roth conversion could pay off more quickly. If the conversion happens at a low tax rate and future RMDs would be taxed at a significantly higher rate, the calculation shifts favorably toward converting.
However, the payoff remains uncertain. Consider a near-retiree who converts at a 22% tax rate, expecting tax rates to revert to 25% after the 2017 tax cuts expire in 2026. If lawmakers extend the cuts, the tax-savings rationale disappears. This uncertainty underscores the speculative nature of Roth conversions.
Beyond legislative risks, longevity and heirs’ tax rates also affect the equation. Heirs have 10 years to take RMDs after the original owner’s death, potentially at lower tax rates than the retiree faced. Even under stable tax rules, Roth conversions take many years to become worthwhile.
McQuarrie compares a Roth conversion to extending a long-term, zero-interest loan to the federal government. The “interest” comes in the form of future tax savings, which depend on unpredictable tax code changes and life expectancy. Framed this way, Roth conversions seem far less appealing.
