Successful tax planners understand the value of Roth savings. A short-sighted or simplistic approach to Roth conversions could lead to having less after-tax net worth over the long-term.

In a Kiplinger article, Brian G. Madgett presented incorrect reasoning regarding Roth accounts. In “Take the Scenic Route: Diversification on the Road to Retirement ,” Madgett shows his mistake when he writes:

I am often asked, what’s better: a pretax retirement plan — such as a 401(k) or a traditional IRA — or an after-tax retirement plan — such as a Roth IRA or Roth 401(k). My answer is always the same: It depends. If you defer your money in a high tax bracket and later withdraw it from a lower tax bracket, pretax investing is advisable. However, if you defer in a lower tax bracket and withdraw from a higher tax bracket, after-tax investing is advisable. And — to complicate things even more ‐ if you defer from the same tax bracket you are in when you withdraw, then it’s tax neutral between the plans.

Madgett is saying that the primary goal is to pay the least tax when assets are removed from a traditional IRA. However, this advice ignores what happens to your other savings accounts. There is a great cost for assets in held a regular taxable brokerage account.

Taxes related to traditional IRA withdrawals only happen once. Meanwhile, the funds in your taxable account are subjected to taxation each year.

Interest, dividends, and realized capital gains in taxable accounts each face the headwind of annual taxation. Measures taken to shelter assets elsewhere cost taxes upfront. However, these upfront costs reduce the size of your taxable account which in turn reduces your future annual tax burden.

While qualified dividends and capital gains are taxed at lower qualified rates, ordinary dividends and interest are taxed at your full income tax rate, causing a taxable drag of between 1.5% and 2% annually.

When you have $100,000 in a traditional IRA, the government has a lien on your money. If you have an effective tax rate of 30%, it is as though $70,000 is yours and $30,000 is the government’s. When you do a $100,000 Roth conversion, you confiscate the government’s $30,000 and now the entire $100,000 is yours. But the government wants its tax, so you have to pay $30,000 out of your taxable brokerage account.

Paying the tax out of your taxable account reduces the amount which is generating future tax liability. This is why we say, “You don’t have to pay the tax; you get to pay the tax.” Paying the tax on your Roth conversion from your taxable account saves you money in subsequent years. This can be true even if your future tax bracket is lower or the same as your current tax bracket.

When you do a Roth conversion and pay the tax out of your taxable account, you are both removing the lien that the IRS has on your traditional IRA and sheltering assets from the annual tax burden of your taxable brokerage account.

Another way of thinking about the $30,000 of tax from your taxable account is that it is a $30,000 contribution to your Roth IRA to remove the government’s lien from your retirement assets. It isn’t really a Roth contribution, but the effect is the same: Money leaves your taxable account where is it taxed every year and goes into your Roth IRA where it will never be taxed again.

While this savings is complicated to calculate, the savings every year can be quite large. You can simplify the way you think about this savings by imagining that whatever you pay in tax, you will save 1.5% to 2% of that money every year in the future. This 2% annual savings can quickly overcome a one-time 2% or 3% additional marginal tax, especially since the payback never has to stop. Sheltering assets from a taxable account in a Roth IRA creates annual savings as long as that money stays in the Roth IRA.

None of these tax effects are accounted for with simplistic advice regarding Roth conversions. This method of thinking requires complex, long-term, personalized tax planning.

The value of doing systematic Roth conversions is often much higher than people expect. As part of our tax planning service, we model everything we know about a specific client’s situation, and then approximate doing their taxes in mock every year until they reach age 100. After modeling this baseline, we then try various scenarios and compare the client’s after-tax net worth in each case to their baseline after-tax net worth. Often, it takes several scores of these scenarios to estimate how much the optimum Roth conversion might be worth.

There are many ways Roth conversions produce tax savings. One method of savings is getting to pay the tax on a Roth conversion. This is true even though the tax on your Roth conversion can feel more painful than other taxes.

Photo by Lidya Nada on Unsplash. The image has been cropped, duplicated, and one version flipped.