by Archie M. Richards, Jr.
July 16, 2007

A reader's question offers a chance to compare a Traditional IRA with the same investments outside of an IRA.

Neil writes, "I have over $400,000 in a Traditional IRA. At 56 years old, should I convert all or part of my Traditional IRA to a Roth IRA?"

I like Roths better than the Traditionals, Neil. But the conversion incurs income tax at high ordinary rates. This taxable income piles on top of your salary income, with the combination taxed at up to 35 percent.

Our federal tax system is progressive. For married persons filing jointly, the first $14,000 of taxable income is taxed at only 10 percent; the next $43,000 at 15 percent; the next $58,000 at 25 percent; the next $60,000 at 28 percent; the next $137,000 at 33 percent, and income above $312,000 is taxed at 35 percent.

As a single person, the tax burden is higher.

Converting your entire Traditional IRA to a Roth in one year would incur $400,000 of taxable income. Assuming $50,000 in salary, your tax, according to www.dinkytown.com, would be $125,961, which is 28 percent of $450,000. You'd be subject to all 6 tax brackets, including the highest.

How much you should convert to a Roth this year depends on your overall financial situation. Talk with a financial planner (www.napfa.org) or perhaps a tax specialist such as H&R Block.

Traditional IRAs aren't as helpful as people think. Here's a comparison with outside investments:

Assume you invest $4,067 a year in an IRA. At 10 percent a year, the funds grow in 25 years to $400,000.

You convert to a Roth, paying 28 percent federal tax. The tax is $112,000, leaving $288,000.

Alternatively, you invest your money in a regular account outside of an IRA. $4,067 is available each year, but those contributions are first reduced by tax at the assumed rate of 15 percent. The tax is $610, leaving $3,457 for investment.

The investments outside the IRA are the same as those inside. But the earnings are subject to 15 percent tax, reducing the annual gain from 10 percent to 8.5 percent.

$3,457 invested each year, invested at 8.5 percent a year, grows in 25 years to $272,000.

Now for a comparison: With the IRA, you end up with $288,000. Without the IRA, you end up with $272,000. That's only 5.6 percent less - probably not as much difference as you'd expect.

The IRA money ends up in a Roth, where it continues to grow tax free indefinitely. This argues in favor of the IRA approach.

But the Traditional IRA has disadvantages:

• At death (assume no Roth conversion), the heirs of the Traditional IRA continue paying income tax on withdrawals at ordinary rates. Not so for the outside account. There, the tax costs are "stepped up" to the date-of-death values. The unrealized capital gains are wiped out by death. No one ever pays capital gains tax on the accumulations up to the date of death.

• You may have paid high interest rates on credit card debt because of your reluctance to withdraw from the IRA.

• If you have an outside account along with an IRA, you can't rebalance between the two accounts, because any IRA withdrawals incur extra taxes.

• With the investments inside the IRAs not taxable, many people trade IRA money more rapidly than they do outside accounts. The more trading, the worse your long-term results.

• Finally, IRAs are subject to complex rules, especially regarding their inheritance. These cause people to suffer large and unnecessary tax costs. Advisors can prevent the mistakes, but advisors cost money, too.

Yes, Traditional IRAs have their advantages. But the disadvantages seem greater to me.