February 9, 1998

Q. My wife and I currently have about $140,000 in mutual fund IRAs. I am confused as to whether we should convert these traditional IRAs to Roth IRAs and pay the taxes owed. I am also uncertain whether we should continue making contributions to these regular IRAs or open Roth accounts for new contributions. We are both 43, are in the 15 percent tax bracket, and expect to be in this bracket for the rest of our lives. My two concerns are paying the taxes owed -- we likely would have to pay a portion from the IRA savings -- and the loss of our current $600 annual tax savings, which we use to make deposits into a supplemental long-term savings account.

E.K., Nashua

A. If you go strictly by the numbers, and if your assumption that you'll always be in the 15 percent tax bracket is accurate, there is no difference in the after-tax value of savings accumulated in a traditional IRA and in a Roth IRA.

But, tough as it may seem to turn a big portion of that hard-saved money over to Uncle Sam, I suggest you convert to the Roth. There are a number of reasons for this, but the three most critical are:

1. Although you believe you will always be in the 15 percent tax bracket, it is likely that in your retirement years you will find yourself creeping to the higher brackets -- unless, of course, you have already paid the taxes on your most vital savings.

2. The Roth IRA allows individuals to lock in tax liabilities at their current tax rate. Since you're now in the lowest bracket, why not?

3. You are probably 20-odd years away from retirement, and there is no guarantee that tax rates won't rise over those 20 years, or during the years after you retire. With the Roth, you can pay now and forget about it.

As to the first point, I don't know how your IRAs are invested. If you have very cautious IRAs -- such as money markets or bond funds -- the assumption that you will forever qualify for the lowest tax bracket might be warranted. But if they're invested more aggressively, such as in stock mutual funds, your good savings habits will very likely take you beyond the 15 percent bracket.

Let's begin by looking at numbers that should be reasonable if you have your IRAs invested in stock vehicles. If you keep that $140,000 in traditional IRAs for 20 years, presuming 10 percent average annual growth, the pool would grow to a healthy $941,849.

If it were withdrawn at a 15 percent tax rate (which of course would mean that the withdrawals would have to be spread over a number of years) it would have an after-tax value of $800,572.

Now let's look at the Roth alternative. If you made the move to a Roth this year, you would have to withdraw $21,000 to pay the taxes (although, for 1998 only, the tax payments on such a rollover can be spread over four years). If the tax money were withdrawn from the IRA funds, the rollover would reduce the IRA balance to $119,000.

But where would you be after 20 years? If you earned the same 10 percent on the account, the number would be $800,572-- precisely the same as the after-tax figure for the traditional IRA.

You might argue that you could, in retirement, make withdrawals from such a pool and still stay within the 15 percent bracket. But remember: These numbers are simply projections of the growth of your current IRA savings. If you keep saving at the same rate during your remaining pre-retirement years, the numbers will be much higher, and the ability to stay within the lowest bracket increasingly problematical.

To demonstrate this, I'll use what may be an extreme example:

Suppose you and your wife keep those traditional IRAs untouched for the 28 years until you reach age 70 1/2. By that point, again presuming 10 percent average annual growth, the pool would be worth $2,018,939.

At that point, you would have to begin mandatory withdrawals, and with such a balance the amount (which is based on your joint and last survivor life expectancy) would be $98,006 for the first year. Such a figure would make the 15 percent tax bracket nothing but a pleasant memory.

It is true that if your investments are very conservative you might remain in the lower bracket in retirement. If your $140,000 earned 6 percent annually for 28 years in the traditional IRAs, the account would grow to $715,363, and the mandatory minimum withdrawal would be only $34,726, which would indeed remain in the 15 percent tax bracket (based on the current rules).

But again, that doesn't include the effect of future contributions on the accumulation, so it remains likely that even with very conservative investments you would have the pleasant problem of a retirement income stream that takes you beyond the lowest tax bracket.

Nor do I think you should underestimate the prospect of higher future tax rates. If you retire at 65, that will be the year 2020 -- just a decade before Social Security is currently expected to go bankrupt. Since there have been no solutions to the crisis, my unhappy guess is that at some point, perhaps sooner than later, this problem will work its way onto Form 1040.

Beyond that, the Roth IRA provides a couple of features beyond tax-free withdrawals.

These are the elimination of the mandatory withdrawal schedules (and the truly nasty paperwork they entail) and the ability to continue contributing to a Roth past age 70 1/2, the latter being a feature that few will probably use, but which is nice to have in any event.

Since you have been amassing the money saved on your taxes because of those IRA contributions, and since those funds are in taxable accounts, why not use that money to pay the taxes caused by the rollover to the Roth IRA, thus maximizing the number of dollars rolled over. Obviously, if you treat that pool both as emergency savings and as a supplement to your retirement accounts, you won't want to empty it.

As for future IRA contributions, I would follow the same reasoning.

In a pamphlet called ``Understanding the Taxpayer Relief Act of 1997,'' the Vanguard Group analyzed the long-term effect of the kind of savings plan you have been following. Its example presumed a taxpayer in the 28 percent bracket, and 8 percent average annual growth from investments. The bottom line is this:

If a person made a $2,000 contribution to a traditional IRA, the IRA pool would grow to $9,332 after 20 years. But, of course, taxes would be due when the funds are removed, and this would reduce the amount to $6,719.

If that person invested the $560 tax savings from the IRA in a taxable account, the account would grow to $1,716 (after being reduced by the 28 percent tax bill each year) after 20 years.

The grand total of the two accounts would be $8,435. And the Roth IRA? It would grow to the same top-line value of $9,332 as the traditional IRA, but in this case the top line is also the bottom line, and thus the Roth IRA saver is ahead by $897.

Is there a disadvantage to taking the all-Roth route rather than the traditional IRA augmented by taxable accounts built upon the tax deductions? Sure. This is that all of the Roth saver's money is tied up in the illiquid Roth, where, with a few exceptions, it cannot be withdrawn without penalty until age 59 1/2 and until the money has been in the account for at least five years.

The exceptions include death, disability, the first-time purchase of a home (with this penalty-free withdrawal limited to $10,000), educational expenses, health insurance premiums for unemployed people, and, finally, substantially equal periodic payments taken over the owner's life expectancy. But I think the pluses provided by the Roth outweigh the disadvantages.