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Roth IRAs are the darling of the financial media. Maybe it’s because they’re relatively newer. Or because the rules have changed, allowing more people to access them now. Or because, in some situations, they can save you more on taxes.

Whatever the reason, there is a pervasive belief that Roths are somehow a better place to park your money. I’ve even seen the decision to do a Roth conversion called a “no-brainer.” But are Roths really the great deal they’re made out to be? My own brain has been swimming in the details of Roth IRA conversions recently. And I can tell you the decision is not so obvious to me.

When you run the numbers, while holding other variables constant, it turns out that Roth IRAs have no magical tax reduction capabilities. They are a financial vehicle like any other — sometimes effective, but not always the best tool for the job.

We’ll look at those numbers shortly. But first, be forewarned that I have a strong distaste for adding complexity and paperwork to my life just to save a few bucks. Especially if that payoff involves parting with my money sooner than later, or requires predicting the future accurately. But your preferences or financial situation could well be different than mine. There are scenarios where Roths can save you money, particularly for those in higher tax brackets. So, put my data and insights about Roth IRAs and Roth conversions in context, and draw your own conclusions….

Roth IRAs

Though I’ve never had a Roth account (our income precluded it during most of my working years), like most people these days, my default instinct would be to “choose a Roth.” I helped my son set up a Roth account when he started receiving his first income from work. Roths are the conventional wisdom for young people starting out, because their tax bracket will probably rise later, and they may want penalty-free access to their savings for buying a first house. And I don’t argue with that.

But, it’s often implied that, given a certain sum, the Roth’s “tax-free” nature somehow leaves you with more money in the end. However, assuming your tax bracket remains the same, that simply isn’t true, as an example will demonstrate:

Suppose you’re in the 15% tax bracket and you have $5,000 to put to work in a retirement account. In a Traditional IRA account that gives you a starting balance of exactly $5,000, because the contribution is before taxes. But in the Roth account, which is after taxes, you’d have just $4,250, after paying your 15% taxes first from the initial sum.

Assume you’re getting about a 7% return. Ten years go by, and your investments have doubled in value. Now you have $10,000 in your Traditional account and $8,500 in the Roth.

Now it’s time to withdraw and use the money. (We’ll ignore various time limits and penalties which are irrelevant for this example.) The Traditional account is taxable, so when you pull out the $10,000, you must pay your 15% tax, leaving you with $8,500. The Roth however is tax free, so when you pull out the balance, you get to keep the full amount. You wind up with $8,500, just like the Traditional.

So, there is no difference in the ending values of the two accounts, assuming your tax rate is unchanged between the initial contribution, and your withdrawal. (Thanks to Mike Piper at Oblivious Investor for making this commutative property of multiplication crystal clear.)

If your tax rate changes, though, the story is different: If your tax rate goes down, a Traditional IRA does better. And if your tax rate goes up, then the Roth does better.

It makes little sense, in my opinion, for most near-retirees to assume their tax rates will rise. Yes I know we have enormous public debt and the government will need to raise that money somehow. General tax rates could go up in the future for political/budgetary reasons. But, it is highly likely that your personal taxable income in retirement, and thus your tax rate, will be significantly less than it was while you were working — which is the main comparison that matters for retirement saving. This has to be the case, almost by definition, for anybody who lives off what they put away during their working years. (Personally, not only are our tax rates lower in retirement, they are dramatically lower.)

So Roth IRAs are not a slam dunk for tax savings. It all depends on whether your tax rate changes, and in which direction. Still, for the record, Roths do have a few inherent advantages over Traditional IRAs:

• No age limit on contributions
• Take out original contributions tax and penalty-free
• No tax on inherited accounts — because you already paid the taxes
• No Required Minimum Distributions (RMDs) — again, because you already paid the taxes

(But note that taxable accounts, of which we have plenty, have very similar benefits!)

Required Minimum Distributions (RMDs)

Now, let’s quickly review Required Minimum Distributions (RMDs) — also sometimes referred to as Minimum Required Distributions (MRDs) — a key component of the Traditional/Roth IRA decision. As we saw above, your contributions to Traditional IRAs are tax deductible. The government wants to encourage retirement saving, but it also wants to make sure you pay taxes eventually. Hence the RMD rules: You must begin withdrawing from any Traditional IRAs starting at age 70 1/2, and you must include those withdrawals as part of your taxable income. (Note, you don’t have to spend the money! If you don’t need it, you can put it directly into a taxable savings or investment account.)

How much are you required to withdraw? The amount of your RMD is calculated as your Traditional IRA account balances divided by a “distribution period” (your life expectancy) from the IRS’s Uniform Lifetime Table. For most people, the distribution period at age 70 1/2 is 27.4, which equates to a 3.6% withdrawal rate. And the withdrawal rate goes up gradually from there, as you age. The government can require you to withdraw a larger percent each year, because you have less time to left to live. Cheery thought.

RMDs are a nuisance to those with very large IRA account balances and the dwindling few who receive pensions, because they generate unnecessary taxable income — money you don’t need for living expenses, that will be taxed anyway. Even worse, in some scenarios, RMD’s along with Social Security can force you into a higher tax bracket. That means you’re required to give an even higher percentage of your money to the government. And nobody likes the sound of that.

The lack of RMDs is often cited as the primary benefit of Roth IRAs. And indeed it could be, but that’s far from certain for many people. As I’ll shortly demonstrate with my own situation, and as others have pointed out, RMDs are a moot point for many of today’s retirees without pensions. Why? Because for many people, the problem isn’t being forced to take out more than they need — it’s not having enough retirement savings in the first place! The majority of us will need to make substantial withdrawals from our IRAs to make ends meet in retirement. So the government’s RMD rules may not force much, if any, “extra” income on us.

Roth Conversions

Because of the perceived threat of RMDs pushing you into a higher tax bracket, the conventional advice is often that you should “top-off” your tax bracket in low-income years of early retirement by doing a Roth Conversion. What is a Roth Conversion, exactly? Well, it’s similar to an IRA rollover. It usually involves setting up a separate account to receive the funds. And, as with rollovers, it’s always best to do a direct transfer at the same institution or between institutions, rather than taking custody of the money yourself and dealing with deadlines and possible penalties.

Now the catch: After the conversion, you must pay ordinary income tax on the converted amount for the tax year of the conversion. Importantly, you do NOT want to use funds from the IRA to pay these taxes. For starters, if you are under age 59 1/2, you would incur a penalty. More generally, you lose out on some potential tax-deferred growth….

The mechanism for this is not well explained elsewhere. I spent quite a bit of time with a spreadsheet, getting a handle on it myself. It’s important because it represents one of the few inherent advantages of a Roth. There are several ways you can understand it: Paying conversion tax from your non-IRA funds is almost like a form of leverage, borrowing from yourself to buy a tax-advantaged investment. But, the amount you have to “reimburse” yourself in the end is less, because it would have been growing at a slower rate in a taxable account. Essentially, with the option to pay the conversion tax from non-IRA funds, the government gives you the opportunity to tax-shelter a bit more money: an amount equal to the conversion tax you’re required to pay.

In case this topic isn’t confusing enough yet, note that if you made any non-deductible/after-tax contributions to your Traditional IRA (I have some of these), you can’t simply convert that portion to a Roth. Rather, the IRS requires you to pro-rate each conversion to determine how much is taxable. This will likely complicate your record keeping for the year of the conversion, and for years to come.

(I will not be discussing here what has been called a “backdoor” Roth IRA conversion — where high-income individuals make non-deductible contributions to a Traditional IRA, and immediately convert them to a Roth. That’s a different bag of worms, though some of the issues are the same.)

Analyzing a Roth IRA Conversion

This past 2014 tax year was the first time in my early retirement where our income was both low enough, and I had enough free time and information, to seriously evaluate doing a Roth IRA conversion. I plunged in, little suspecting this would be one of the most complex retirement calculations I’ve yet encountered….

For starters, I use some of the dedicated Roth IRA Conversion calculators available online. The two best that I found were:

• CalcXML
• FinancialMentor

These calculators feature similar inputs and similar results. Assuming that my tax bracket stays constant in retirement (more on that later), both of them report that I would be able to generate about 3% greater annual income if I convert our Traditional IRA to a Roth. That is provided I pay the conversion tax from non-IRA assets. If I pay the tax from IRA funds, there is no difference in the net value to me of doing a conversion.

These dedicated calculators are good for a quick answer. But I still didn’t feel I had a good understanding of why a Roth conversion could save me money, or of how doing one would interact with our RMDs, Social Security income, and tax brackets in later years. So, to get a better understanding of the math, while hoping for a more accurate picture of our future, I next ran three of my recommended high-fidelity retirement calculators:

• J&L Financial Planner
• Fidelity Retirement Income Planner
• PRC2015/Gold

The first two don’t analyze Roth conversions specifically, but do model RMDs. In both cases they show modest levels of RMDs into our 90’s that don’t change our tax bracket. That implies there would be no major financial advantage to performing Roth conversions in our case. (Though there might be a modest advantage, a few percent, due to the financial “leverage” of paying the conversion tax out of non-IRA funds, as discussed above.)

The last calculator I used was PRC2015/Gold from Pralana Consulting. This is one of the most sophisticated high-fidelity retirement calculators. It incorporates detailed federal tax calculations. And, not only does it compute RMDs, but it can also perform Roth conversions over one or more years. It can even optimize the total percentage of tax-deferred savings to convert, based on your financial situation. Lastly it offers very detailed output reporting including year-by-year tables displaying parameters like adjusted gross income, taxable income, and effective and marginal tax rates, that are critical for understanding your tax situation in retirement. (Special thanks to Stuart Matthews at Pralana Consulting for technical support and enhancements.)

The picture of my situation emerging from PRC is more complex. It shows an increase in net worth of from 5-10% when doing Roth conversions, depending on whether I use the default tax calculations or tweak the Average Tax Rate on Regular Savings to reflect that I’m relying on low-tax cash and long-term capital gains in these early retirement years. Given the complexities involved, the mechanism for that relatively larger 5-10% improvement isn’t perfectly clear to me yet. It may be related to changes in marginal tax rates, possibly a higher marginal tax rate due to the incremental taxation of Social Security and other government benefits — a topic I won’t tackle just here.

Given the variation in results from the commercial calculators, I created my own spreadsheets to further analyze and understand the factors related to RMDs and the Roth conversion decision. My spreadsheets show us maintaining our current 15% tax bracket, with headroom to spare, and project only a 2-3% benefit to net worth from doing Roth conversions.

That few percent difference seems well within the margin of error for retirement calculations: I wouldn’t count on ever seeing it. If I was certain of a larger increase in net worth, I’d probably consider doing Roth conversions. But, I’m just not confident that my data input has captured all the nuances of my tax situation, or that I can even predict that situation with enough accuracy far into the future. Our tax returns have been substantially different in each of the first two years of our retirement and probably will be different again this year. So, further study is required, plus some additional years of retirement living….

Lessons Learned

I may not have the ultimate answer yet, but I’ve learned some things in my time studying Roth IRAs. For starters, when trying to understand tax brackets far into the future, it is best to show all your analysis results in current/today’s dollars rather than inflated/future dollars. This makes it much easier to view and assess tax brackets over time, because it removes the effects of inflation. Different calculators do this in different ways. (For those that can do it at all, search for “today’s dollars” in my calculator list.)

In the end, RMDs and Roth conversions produce some of the most complex retirement scenarios I’ve ever analyzed. I’d be very skeptical about any simple rules of thumb for using, or not using, Roth IRAs. I think you have to run your own numbers and, even then, the quality of the answers will be limited by your ability to predict precise details about your income far into the future. Nevertheless, after all the number crunching, I did get insights into some of the conditions that can favor doing a Roth conversion in early retirement:

• Having substantial non-IRA assets (Social Security, taxable accounts) such that you don’t need RMDs
• Experiencing higher real rates of return (RROR)
• Having very large IRA-based assets at age 70 1/2
• Having large living expenses that require withdrawing extra income from retirement accounts

Some hope that Roth conversions will be a “silver bullet” to save them from high taxation of their retirement assets. But, realistically, the impact is muted: The amount you can convert is limited by the number of years you spend in a lower tax bracket and your “headroom” to the next higher bracket.

Just how much money can you potentially save? Assuming you had 10 years until RMDs started, and you could realize a tax savings of 10% between brackets, and you converted $30K/year, you would save $30K in taxes over the course of your retirement. That’s nice money, but if you have the assets to convert that much in the first place, it’s probably not a game changer.

Why I Didn’t Do a Roth Conversion Last Year

A salesman knocks on your door. He’s hawking a sophisticated new tax shelter. Pay thousands of dollars in extra taxes now. Then, if you live into your 80’s and 90’s, and a dozen other variables hold true, you will possibly increase your net worth by a few percent. Interested? Some people would be. Not me. At least, not yet.

The Roth conversion decision is all about trading off present certainty against future uncertainty. Maybe you’ll come out a little bit ahead later, if you pay more taxes and add more paperwork to your life now. But, when it comes to retirement calculations, after I’ve had to make 3 or 4 assumptions about the future (investment returns, inflation, tax rates, lifespan, etc.), I begin to discount the results. And Roth conversion calculations require a lot of assumptions.

You won’t find many financial advisors saying: “Do nothing, you’ll be fine.” That dull message doesn’t sell financial services or content. But my goal is to minimize time spent managing money, while maximizing the rest of life. Unless significant sums are involved, or there is some threat that I won’t meet my financial goals, then my default behavior is to “let it ride.” Given the uncertainty in most of the Roth-related variables, if you’re in a lower tax bracket and expect to stay there for most of your retirement, I see nothing wrong with foregoing Roth conversions. That’s what I’m doing, for now.

But, as I’ve said, this is one of the most complex retirement scenarios I’ve ever analyzed. I may have overlooked some factors. And my financial situation probably doesn’t match yours exactly. So, if in doubt, use one or more of my recommended retirement calculators to run your own numbers….