Should you convert ALL of your retirement savings to Roth?

Recently on The Simple Dollar blog, there was a discussion about future tax rates. Gail posted the comment:
"I am 56 with all my retirement funds in both Roths and traditional IRAs. I am working on a 10 year plan to complete converting all my traditional IRA funds to Roth IRAs by the time I qualify for regular Social Security. Why? Two reasons, neither very complicated. First, regardless of tax rates, I prefer knowing that I won’t have to worry about paying taxes at a time in my life when I may not be able to afford it as easily as I can now. (Same reason why I paid off the mortgage on the house). Second, assuming my investments outperform me, my children will not need to pay taxes on the Roth when they inherit and begin withdrawals.

I believe that Gail's plan to convert all of her tax-deferred retirement savings goes against her goals. While I believe that marginal tax rates will increase in the future, I also believe that there will be a certain amount of Adjusted Gross Income which is not taxed -- your personal exemptions and standard deductions. In 2007, the amount of AGI not taxed is $9800 for a single person 65 or older.

For this discussion, let's assume that Gail's investments do slightly better than the inflation rate. For this discussion, the dollar figures will be in 2007-equivalent dollars. Let's say she has $100,000 in traditional IRAs, and that her marginal tax rate is 15%. If she converts it all to Roth IRA, then it will cost her $15,000 in taxes, leaving her with $85,000. If she follows the 4% rule-of-thumb for withdrawals, then she would withdraw 4% of $85,000 or $3400 of it. And yes, all $3400 of that money would be tax free. In reality, the added taxable income from the conversion likely would put her into the 25% or higher bracket, leaving her with less money, only $3000.

Now let's say we were able to persuade Gail to leave the $100,000 in traditional IRAs. She reaches retirement with $100,000 tax-deferred, pulling out 4% or $4000 the first year. Will she pay any taxes on that amount? At first glance, $4000 is less than the $9800 sum of standard deduction plus personal exemption, so you'd expect that no taxes are due. However, the possibility of part of her Social Security being taxed should be considered. If half of her Social Security benefit + all of her other taxable income exceed $25,000 then she would have to add some of her Social Security to her Adjusted Gross Income (AGI). Let's say that she gets $1500/month or $18000/year in Social Security. Half of that ($9000) added to the $4000 equals $13,000. So none of her Social Security gets added to her AGI, and since her AGI of $4000 is less than $9800, she pays NO TAXES anyway.

But we're not done. While I expect standard deduction and personal exemption values to be indexed for inflation, the $25,000 test amount is not indexed. Let's say that over the next couple of decades, inflation doubles and erodes this to the equivalen of $12,500 in 2007 dollars. In that case, she would have $250 of Social Security added to her AGI, resulting in an AGI of $4250, none of which would be taxed.

Let's say that inflation continues for another decade and erodes the test amount to the equivalent of $6250. In that case, $4950 of Social Security will be added to the $4000 resulting in an AGI of $8950. Still less than $9800, so none of it will be taxed.

So by not converting all of her traditional IRA money to Roth IRA, Gail has extra money ($4000/year instead of $3400 or even less if taxed at greater than 15%). As far as the taxes to the heirs, if she converts the money to Roth IRA -- sure, it won't be taxed. But there will be less of it to not be taxed. Said another way, if she leaves it as tax-deferred savings, her heirs would have to pay taxes but would have more money to start with which to pay the taxes. Will they be better or worse off? Depends on Gail's tax rate now Vs their tax rate when they inherit it.

A more important consideration than optimizing taxes for your heirs is ensuring that you're not a burden on your heirs in the event that you don't die. Keeping some of your retirement savings as tax-deferred (traditional IRA or 401k) is a good strategy to increase money available for spending in retirement and reduce the likely-hood of having to depend on your heirs.

However, if you have too much money in tax-deferred savings, some or all of your Social Security benefits will be taxed. At the initial level, $1 of taxable income can result in $.50 of Social Security being taxed, and with additional income $.85 of Social Security can be taxed for each $1 of other income. This effectively raises a 15% tax rate to either 22.5% or 27.75%, and a 25% tax rate to either 37.5% or 46.25%. Not very attractive if you saved only 15% or 25% in taxes during the year that the funds were deferred. And if marginal tax rates increase, it's even worses.

Because of the taxation of Social Security benefits, I am converting tax-deferred savings to Roth IRAs. But I still intend to keep some amount of retirement savings as tax deferred.