Saturday, January 09, 2010

"The so-called value of tax-free Roth income is just goofy...."

I was reading up on the Roth conversion for 2010 and found this article from

With all this talk about Roth IRA conversions available to everyone in 2010, I don't see the attraction. It seems so simple to me to understand that if I don't write a big check to pay the taxes a conversion requires, I will have a lot more money, along with compound earnings, to pay whatever taxes I might owe on future distributions.

Plus, I control all the money and I have hedged my bets against what might be changes in tax policy or another market crash over the next 40 years.

I agree. I just don't understand all the people who think that converting to a Roth IRA in 2010 is a a good idea. Do you?



Blogger Ern said...

Yes, I do. I develop software for personal financial planners, and this has been something on which I've worked recently.

If you convert the funds to a Roth IRA and use other funds (from your checking account, or get them by selling securities) to pay the taxes, you now have the same amount in a Roth IRA that you had in your conventional IRA prior to the conversion, but, unless Congress changes tax law, they will not be taxed on withdrawal, while funds in a conventional IRA will be taxed at ordinary income rates (the same rates at which your salary is taxed, except that you won't pay FICA tax on IRA withdrawals) when they are withdrawn. Depending on the source of the funds to pay the tax on the conversion, you may have to pay tax on part of those funds. If you have the cash, you won't have to pay taxes. If you have to sell, e.g., some stock, you will pay taxes, but, if you've held the stock for more than a year, you will pay the federal tax at the long-term capital gain rate, which is currently 15%; it will increase to 20% in 2011, unless there is a change in the tax law.

So the advantages of the conversion to a Roth IRA are:

1. you can have as much money in a tax-free retirement account as you had in a tax-deferred retirement account, although you will have less in other funds

2. since federal income tax rates will increase in 2011 (and thereafter) unless Congress changes the tax law, you will be paying federal income taxes at a lower rate than you would be when withdrawing in future years.

Is it guaranteed to be the right thing? No, for several reasons (what follows is most probably not a complete list):

1. Congress may decide at some point to tax withdrawals from Roth IRAs. I have no idea whether that will happen, nor do I think that I have any particular expertise about it, but it's possible.

2. I have spoken only of federal income taxes above. The state will tax funds withdrawn for any conversion, as well, and if, for example, you move from California or New York (which have high state income taxes) to Texas, Florida, Washington, or Nevada (among others, which have no state income taxes), your overall tax rate may be lower when you make withdrawals.

3. If you have to use funds from the existing IRA to pay the taxes on the conversion, you will pay not only taxes at ordinary rates (28% federal for a medium-high income tax payer) on the entire amount withdrawn for the conversion, but also a 10% penalty on any amount withdrawn to pay taxes, unless you have reached the age of 59-1/2 as of the conversion. It is unlikely that the conversion will make sense.

Hope this helps.

10:55 AM, January 09, 2010  
Blogger J. Bowen said...

The gargantuan white elephant in the room is the potential for changes in tax policy by Congress. If I didn't already have a Roth yet I'd be hesitant to gamble on whether or not Congress was going to change the tax policies towards Roths, especially considering the fact that there is a huge budgetary problem that is only likely to get worse in the future (you old folks are going to bleed us young folks dry with all of your demands for this service and that service from the government).

11:49 AM, January 09, 2010  
Blogger Earth Girl said...

It depends on your current tax situation and your best guess on what taxes will be in the future. I turned 59 1/2 this year and withdrew 10% from my roll-over IRA. I will pay 2009 tax rates on this withdrawal, but our 2009 income is low because of job changes. If I waited to withdraw until 70 1/2, I feel certain I would have a much higher tax burden. Baby boomers were sold on IRAs because the tax rate would be so much lower when we retired; this is something we need to reconsider in our financial planning.

12:49 PM, January 09, 2010  
Anonymous Anonymous said...

There is one rather nice non-tax feature of Roth IRAs: there are no mandatory distributions.

3:23 PM, January 09, 2010  
Blogger Unknown said...

All of this is irrelevant. Congress will confiscate IRAs and 401k plans in order to bail out Social Security. It's only fair, right?

9:34 PM, January 09, 2010  
Blogger vivictius said...

There has been talk about them moving in that direction Cogito...

10:04 PM, January 09, 2010  
Anonymous Anonymous said...

I wonder what they'd do if your IRA can't buy Treasuries. For example, because it's invested in illiquid assets that can't be sold.

11:24 PM, January 09, 2010  
Blogger Tom said...

When Roth conversions first became an issue, I ran two spreadsheet scenerios: conversion vs. nonconversion, using mainstream figures for rates of return and for marginal tax rates and redemption amounts by age. The bottom-line outcomes were close, but nonconversion actually proved to be advantageous over conversion. Don't believe the hype. Roth conversion myth: busted.

4:05 AM, January 10, 2010  
Blogger Peter G. Miller said...

Tom --

Is there a way to get your spreadsheet?

I had this conversation with someone the other day and did not have an informed view, one way or the other.

If you do have mandatory distributions after a given age you may also be in a lower tax bracket than during your peak earning years. That may be a better choice then conversation when rates are higher.


6:42 AM, January 10, 2010  
Blogger Ern said...

Peter -

e-mail me at lonesome_picker at that site that begins with a y. I'll send you mine. It says that conversion is worth it, provided you pay the taxes out of funds other than your existing IRA and there are no taxes on Roth withdrawals; I'm going to modify it to allow for taxes on Roth withdrawals, because it looks to me as if the conversion is worth it even when taxed, provided the tax rate is low.

10:29 AM, January 10, 2010  
Blogger Dan said...

Just ran the numbers myself and for every dollar I put into a ROTH conversion I would pay over 25 cents cents in state and federal taxes.

That is real money that can be invested today in an actual ROTH or in a long-term account.

The ROTH conversion story may be applicable to some but it seems the smarter play is to keep both the tradition IRA and invest new money in a ROTH, as well as pay down debt and add to personal savings.

9:48 AM, January 11, 2010  
Blogger Wayne said...

As J. Bowen said, the real issue is the possibility of tax increases in the future. The Bush tax cuts are set to expire, so Tom, you should run your spreadsheet with that in mind.

4:14 PM, January 11, 2010  
Blogger Larry J said...

My wife and I have old IRAs and Roth IRAs. Our income was above the limit for deductability on the old IRAs ($40-50k back then) so we used after tax dollars for them. The question of whether to move those funds into a tax free Roth is complicated.

What will our tax rates be when we begin removing money from the old IRAs? If today's laws were in effect, the rates should be lower because our income will be lower. However, if one thing seems certain it's that tax rates are going higher. If anyone is so deluded to believe taxes won't increase unless you're making more than $250K, well, I have some investment property that you might be interesed in buying.

If we convert the old IRA funds to our Roth IRA accounts, we'll have to pay a substancial amount of additional taxes this year. How will that compare to the taxes we'll have to pay on the same money when we retire? How well can we pay the money today when we're both still working compared to when we're retired and needing to live off of our retirement savings? Even if the taxes were the same, our ability to pay is better today than it will be then.

Also, since we're already maxing out our 401Ks and Roth IRAs, would we be better off investing the money we would pay in taxes for the conversion in something else? And what might we invest in?

I don't have answers to any of these questions so it's very hard to make a good decision. While I very much like the idea of having more tax-free income available at retirement (assuming Congress doesn't change the laws before then), it's still far from clear whether converting is a good idea or not.

4:38 PM, January 11, 2010  
Blogger tomcal said...

I'm leaving all of mine conventional, and using the money I would pay in taxes to convert to invest in long-term assets where the appreciation, if any, will be taxed at capital gains rates.

For me, the lack of mandatory distributions from a Roth might make conversion attractive for some, but other than that, I think it is a push. Also, I hate to do anything which transfers my wealth into the government's pocket before I absolutely have to.

Remember that most of the people offering the advice stand to make money from the portfolio adjustments a conversion might require.

5:17 PM, January 11, 2010  
Blogger Andrew S. said...

The reality of having "more money earning you interest" in a traditional IRA is debatable. Remember that, as pre-tax dollars, do you not own all of the money on the account. In order to access it you will have to pay the government its fair share. The "extra" money compared to a ROTH isn't working for you at all - you're investing it for the government. Think of it in terms of percentages rather than dollars and cents.

Let's say you have a traditional IRA vs a Roth, both at 30% taxation, both with a start up investment of $100. In 10 years you earn an average of 7.2%, doubling your money, then withdraw. In a traditional IRA you will begin with $100 and end with $200, but pay taxes of $60. This leaves you with $140. With a ROTH IRA you begin with $70 after you pay the $30 tax and end with $140. Given equal taxation they produce equal results.

The IRA/ROTH argument is pretty simple matter of personal belief when you boil it down this way.

If you believe your personal income tax rate will be lower when you withdraw than when you put in the traditional IRA is a good deal. This way you defer taxation and pay at a lower rate.

If you believe your personal taxes will rise, however, a ROTH is a very good idea. You pay the taxes up front, "locking in" that rate. When taxes rise your withdrawals will be unaffected.

5:20 PM, January 11, 2010  
Blogger Jason said...

I prefer the Roth for most working stiffs, but I don't know what your personal tax situation is.

I definitely recommend reading a book called "The Retirement Savings Time Bomb (and How to Diffuse It"), by the excellent Ed Slott.

The lack of mandatory distributions is a huge factor in favor of the Roth.

10:07 PM, January 11, 2010  
Blogger beebs said...

Delaying a tax until the future is better than paying a tax now. The buildup inside a conventional IRA should be significant, barring another 2000-2010 debacle.

12:23 AM, January 12, 2010  
Blogger Topher said...

"Delaying a tax until the future is better than paying a tax now. "

How? Why?

8:23 AM, January 12, 2010  
Blogger Unknown said...

J. Andrew is correct, with one (in my opinion, very large) caveat:

For the current-day tax rate, you should use your marginal tax rate.

For future withdrawals, you should estimate a tax rate closer to what you expect your average tax rate to be, which will be much lower than your future marginal rate. That is, withdrawals from your standard IRA or 401(k), (a Roth 401(k) may available to you, as it is to me) of the future aren't going to 'on the margin' or taxed at the highest rate, they're going to be the largest chunk of your retirement income, and therefore will be taxed at near your average tax rate.

Simplified example (using no deductions or exemptions, which would change the math somewhat) assuming you work this year and retire next year (to avoid the complications of inflation):

You're single and your AGI is $100k. By taking the deduction now, you save 28% on the money you set aside.

You retire single and tax brackets haven't changed. Assume you're taking $24k in Social Security (the maximum) and making $4k in interest and other income. That's $28k. You'll pay $3.8k on that income, because... to maintain your AGI, you going to take $71k from your IRA. You'll pay $21.7k on your total income, for a 25% tax rate on your retirement withdrawals. If your retirement was in a Roth, you would only pay the $3.8k, but J. Andrew has already shown why it's misleading to think of it that way. It's a wash, but for tax rates.

The bottom line is, use a Roth over a traditional if
1) You make too much money to contribute to a Roth (this is my problem)
2) You expect to have substantial income outside of your IRA. (this could include non-Roth 401(k) distributions)
3) You expect tax rates to go way up, such that your average tax rate in retirement will be larger than your
4) You believe that you'll have a strong desire to put off taking distributions (do the math on this one, though, you can take the distributions and keep them invested in a taxable account)

I welcome any critique of my (and J. Andrews') math. The reasoning above has led me to use my company's traditional 401(k) instead of Roth 401(k), though as I said I have no choice when it comes to tax advantaged IRAs, and if I'm wrong I would like to know it.

10:41 AM, January 12, 2010  
Blogger tomcal said...


"We hold these truths to be self-evident..."

11:25 AM, January 12, 2010  
Anonymous Anonymous said...

How? Why?

Time value of money. A dollar today is more valuable than a dollar 20 years from now.

I did my Roth conversion in a year in which I was unemployed, so I had a very low tax rate to pay.

2:16 PM, January 12, 2010  
Blogger antigam said...

I converted specified shares in an IRA to a Roth based on three factors. One, I'm on the edge of retirement and have the ability to control income and tax rates in 2011 and 2012 So I can lower my rate. Two, I have cash available to fund the tax in 2011 and 2012. Three, aside from the above, if the investment mote than doubles, over the 5 year holding period the conversion is beneficial.
Convert $100,000 to Roth IRA. Pay 25% tax, $12,500 in 2011 & 2012 If Roth account is worth $200,000 in 2015, I'm ahead unless tax rates fall I'm expecting the account to go up 400% to $400,000 which would be taxed at 25 - 33% + in a regular IRA.

Note also that the Roth conversion can be reversed if account value drops.

8:09 PM, January 12, 2010  
Blogger codemonkey said...

Didn't see this in any of the other comments, but one other advantage of a Roth is that the income won't count towards making your Social Security taxable. A fairly minimal income triggers taxation of those funds, and a regular IRA requires minimum distributions after a certain age.

Like a traditional IRA, the compounding is tax-free.

One other thing, if you convert, you have a year to decide to "recharacterize" it back to a traditional IRA if the market falls (so you are hedged against paying the tax, and then watching the value plummet).

If they go after Roth IRAs, they'll also go after other retirement plans, especially since only the "rich" have them.

2:47 PM, January 13, 2010  
Blogger CostelloM said...

This debate is irrelevant - do not worry too much about your IRA's as they'll all be full of worthless treasury bills as soon as the Congress can work out the details. Not to be smug but I saw this coming years ago - you give your money to the government, let it make all sorts of rules for how and when you are allowed to access it, and then people are surprised when they can't get it back? Ever heard of possession being 9/10ths of the law? There is a reason that they don't want you to have it and its nothing to do with anyone trying to protect you. Unless your last name is Goldman or Sachs you are simply cattle to be milked. Studiously adding money to some account somewhere that you can never access until some ever changing list of arbitrary decrees from Mt. Olympus is satisfied is just you paying extra tax throughout your life. The government has consistently punished those who save while actively rewarding themselves and those powerful few that serve their interests so why should this be a surprise?

Here is the article btw and yes this will happen.

Your best bet is to take whatever hideous penalties they assess for accessing YOUR OWN MONEY and take what you can before you lose it all. Trusting the government with your money is like trusting your drunken uncle with your savings in a casino... get it out of their control or lose it forever.

8:19 AM, January 14, 2010  
Blogger Peter G. Miller said...

Some of the comments here reflect the practical reality that it's likely best to diversify assets. Most retirement accounts are set up so that you can only purchase stock directly or indirectly because that's how brokers make their money.

One alternative to consider is the long-term ownership of single-family rental properties. With the population rising and the preference of most people to live indoors, my sense is that such investments can selectively make sense.

Investing in real estate largely moves your money off Wall Street and into your local community.

The tax benefits of investment real estate can be substantial.


9:01 AM, January 14, 2010  
Blogger tomcal said...

Peter: How liquid is it?

9:25 PM, January 14, 2010  
Blogger tomcal said...

Just kidding...

9:25 PM, January 14, 2010  
Blogger Peter G. Miller said...

Tom --

It's a fair point. Not as liquid as stock.


10:26 PM, January 14, 2010  

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