Financial Samurai

“If you move to Hawaii, the state can’t legally tax your pension or retirement contribution”

Well I just learned something new there… thanks for the heads up!
.-= Ryan @ Planting Dollars´s last blog ..Another Day in Paradise for $5.50 =-.

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I applaud you for presenting the other side of the story, Sam. When everyone is shaking his or her head in agreement, no one is using his or her head to think.

Rob
.-= Rob Bennett´s last blog ..Podcast #194 — The Future of Buy-and-Hold Is a Political Question =-.

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Overall, I like the Roth, but not entirely for retirement income. One of the Roth IRA features that I like is… that you can pass the Roth IRA to your kids skipping probate.

Random thoughs on the subject:
I think it’s a good deal until the government change the rules of the game.
I can alway pull out my contributions tax and penalty free at any time.
I like that it can compound tax free.
The Roth IRA is a perfect vehicle for an emergency fund.
I wouldn’t bet the farm on it… If the government is threatening with things such as a “driving usage” (this isn’t law and hopefully it won’t be) and the “cap and trade” tax, who knows what wicked ways they will find to tax your Roth…

My biggest fear is that they will use the extra money taxed this year after the converstion from tradtional to Roth IRA foolishly, instead of reducing the trillions of dollars of stimulus money that has been spent.

I think this opportunity for the 2010 convert to a Roth IRA came from Bush’s era. I do like the idea of spreading the conversion tax over multiple years feature…

If you are late 40-ish or 50-ish, the 2010 conversion option may (actually most likely) not be the best option for you!

I agree that the Roth IRA primarily benefits the 20s or younger age group.

Good to hear a contrarian point of view on the matter! The point being who know what the future will bring, and even this Roth IRA is a gamble.
.-= Moneyreasons´s last blog ..Creating an Automated Budget =-.

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Hey Sam, thanks for another great post. I hope a lot of people give this a serious read.

There are people who can benefit from a Roth, like people concerned with estate taxes and young investors who expect to be at a much higher income tax bracket when they retire.

But for most of us it makes more sense to put your pre-tax dollars to work generating revenue for you, not Uncle Sam. I appreciate the fact you broke down the numbers; you can’t argue with the math!
.-= David @ MBA briefs´s last blog ..Are you a Red Shirt? 5 ways to survive layoffs and advance your career =-.

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Sam — You make some excellent points, especially as it relates to folks who’ll fail moderately to miserably investing prudently for their ultimate retirement and its income.

The point I’d make is simple: What would you tell a 45 year old sporting $250K in his 401k, with 20 years left before retirement? If they followed your investment advice, they’re likely to beat the markets, ending up with quite an impressive chunk of capital at 65. If they followed this post’s advice, they’ll pay more in taxes in the first 3-7 years of retirement than they saved in taxes during the 20 years of 401k/IRA contributions it took to get there. (I realize this guy isn’t at whom the post is directed)

People ending up with roughly $1.5-2 Mil or more, AND diversified somewhat into real estate, will have significant tax bills with with to deal. If so, it’ll be exacerbated by the fact their cupboard will no doubt be completely out of tax deductions. (Except for those who knew how to avoid the lack of tax shelter :) )

This is, of course, totally in line with what your post says. You’re talkin’ to folks who simply won’t get to retirement with all that much capital. Good stuff, Sam.
.-= BawldGuy´s last blog ..Munchin’ The Numbers — Um, Buy Gold =-.

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Anything the government is doing nowadays should raise serious caution for any investor or even debtor. Consider their fiscal irresponsibility – would you hire a financial consultant who has the track record the federal government does? Ummm… perhaps if you were drunk.

Always study “new” trends in money, regardless of where the information is coming from – but especially when the info is coming from the feds!

IMHO, the Samurai is spot-on.
.-= Matt Jabs´s last blog ..3 Ways to Get Started Investing with $1,000 or Less =-.

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This is a great post on the subject matter. We too cringe at the amount of people who may just blindly be taking the government up on its offer because the gov is so thoughtful…or not. Hopefully, they give your post a good read and reconsider!
.-= Minority Fortune´s last blog ..Water Is the Gold of Health =-.

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Great post, Sam. It’s good to hear the opposite side of the argument since there are so many praising the 2010 Roth IRA conversion opportunity. One thing I do like about it is for someone who does not have a Roth as of yet, it provides an opportunity to diversify tax wise. No one really knows what will happen in the future, tax wise- but this probably only applies to a select few. I agree that most people should not pay taxes until they have to!

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Thanks for this excellent analysis. I just opened a Roth as part of my 401K without much thought last november and just went and changed the contribution amout to go 100% to my pretax 401K. Just this past weekend, I was trying to explain to my husband how the roth is different so this was definitely a very timely article for me.
.-= thriftygal´s last blog ..7 Ways We Throw Money Away by Not Paying Attention =-.

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To rebut your rebuttal, first all, living here in the DC area I now know that the government is definitely not as smart as people think. They make more mistakes than the people would like, especially financial mistakes. Second, depends on you stage in life. I am mid 20′s making mid 20′s lower salary. I would like to hope my salary will increase over time as I get older. For me my taxes and pay increase should raise over time, so the Roth makes sense for me in my mind. Also, I like to keep things simple( sure you can call this lazy or my lack of financial experience) but its nice for me to know exactly what is in my account opposed to trying to figure out how my retirement is affected year after year with the increase in taxes.
.-= Craig´s last blog ..When it Snows, it Snows Money =-.

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I’m actually going to disagree with you on this one. Not so much on the premise, but a couple points relating to retirement.

Counterpoint A:
I will have to check out the income tax article later, but I’m interested in learning how you arrived at 5-10%. I’ll give you that there’s a net discount, but consider what retirement itself is – living off the resources you’ve built. So if most of your cash flow is outgoing, sales tax becomes a consideration. Then expand further to look at the healthcare costs, property taxes, and so on.

This leads into your use of the associative property, which should be expanded to include ALL taxes. Really Y = AB + CD+ EF + GH. That would represent the true benefit of a “no income tax” move.

Counterpoint B:
All equations contain assumptions, and there’s a wide scale to the validity of them. Many are assumed truths and many are hypothesized to be plausible. You throw it out there that the government could introduce legislation to lower tax rates. They could turn around and do something equally as bad – like tax Roth distributions.

Think of it this way. The argument over taxes would become irrelevant if the US govt collapsed right? The stability of the US is an “assumed truth”, but there’s no guarantee that it’s not possible. This was partly why there was that brief media coverage stint on retiring abroad.

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@Moneyreasons

“that you can pass the Roth IRA to your kids skipping probate.” The IRA would skip probate also. I think what you meant to say is that it wouldn’t be subject to the income taxes when they inherit it?

@Sam,

Great Post. If you wrote this post March of Last year, everyone would have crucified you. The fact is this only works if you have outside money to pay the income taxes now. Guess what? Less people have that outside money OR THEY REALIZED THEY DIDN”T WANT TO GIVE THE MONEY TO THE GOV’T NOW! lol
.-= Evan´s last blog ..What is the Estate Tax Trap High Net Worth Individuals Fall into? =-.

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Bottom line don’t take anything the government does it’s for your sake! FS what you are eluding to is all political risk, a factor that’s often not thought about (just like inflation risk)

People are also assuming Roth IRAs will remain they the way they are current setup. I hope so and they are not taxed differently.

I still think Roth IRAs are not a bad deal, they should be part of your retirement strategy not all of it.
.-= Investor Junkie´s last blog ..What is a Master Limited Partnership (MLP)? =-.

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FS – I have to respectfully disagree with you on your second point about people being unlikely to be making more in retirement than in their prime years.

High income earners don’t give up reins at 65, or 75 or any age, so income isn’t limited to earnings on invested capital. I’ve seen this time and again in my accounting career.

As to the rest of us rowing the ship, we can’t count on full retirement at 65 or beyond. Most of us are likely to be working well past, as defined benefit pensions are largely gone and the benefits of medicare become increasingly sparse. Soc sec, wages and investment returns may very well equal higher income even for middle class people.

It’ll all be a product of inflation, but the income numbers will be higher all the same. Bet on continued inflation and higher taxes and you won’t be disappointed. If it’s otherwiswe, we’ll all be pleasantly surprised, but I wouldn’t be banking on the happy scenario playing out, not when it comes to planning purposes.

Rob Bennett (#2) – “When everyone is shaking his or her head in agreement, no one is using his or her head to think.” Truest words ever spoken!
.-= Kevin@OutOfYourRut´s last blog ..Restaurant Tipping – How Much and When? =-.

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As a person who needs to open an IRA of some kind, this is helpful. All I’ve been reading about are ROTH IRA’s. I now need to look into traditional IRAs to see which would be more beneficial for me in the long run. I basically haven’t started saving for retirement (I am so behind!). However, my employer I work with has a pension plan. So instead of Social Security taking money out, my CalSTRS takes it out and my employer matches it. I just don’t know which IRA would best work for me. I’m procrastinating again….
.-= Little House´s last blog ..Cool Calculators =-.

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@Kevin@OutOfYourRut

A very valid point about high income earners.
.-= Investor Junkie´s last blog ..What is a Master Limited Partnership (MLP)? =-.

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Welcome aboard the “Roth Mania” bandwagon. (i.e. you acknowledge it, not promote it.)
I hoped I helped influence your view as it’s in line with what I’ve been saying. The wholesale conversion makes little sense for anyone.
Roth as a deposit is good for those who are just getting started and in the 10 or 15% bracket. A lifetime of earnings may put them in a higher bracket in later years. Also for those who exceed the ability to deposit to a traditional IRA. May as well choose Roth instead of a non-deducted IRA, right?
Retirees who are in the 15% bracket can use the conversion to ‘top off’ the bracket, adding just enough to pay just 15% on the conversion, but not 25%. This will help keep their RMDs from snowballing them into the 25% bracket. A small bit of math that can pay off over time.
.-= JoeTaxpayer´s last blog ..More on Estate Planning =-.

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I’m not qualified to speak about U.S. tax affairs but I am qualified to applaud your cynical attitude Sam.

Governments can and do change tax rules. They might claim not to retrospectively apply tax changes, but all they really mean is they don’t have a time machine, and so won’t bill you for money they might have collected from you earlier.

But in terms of changing the rules after you spent years believing something in good faith – happens all the time.

Our government here in the UK took away a tax credit on dividend income in pensions in the late 1990s that was so boring it was barely noticed when it was announced, and it’s cost UK pensioners billions of pounds a year ever since.
.-= Monevator´s last blog ..Financial advisers: Swindlers and leeches =-.

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@admin
In theory that would seem to be true, but in practice, high earners don’t think the way the working class does.

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I like the counterpoint argument and agree that you shouldn’t just convert a Roth because you can. Each person’s situation is different and has to be evaluated carefully. I agree most of all that it is crazy to pay tax before you absolutely have to.

Personally, I like a balance of regular IRA/401(k) and Roth. That way when I retire, I can withdraw taxable funds up to whatever the exemptions/deductions total (currently $18,700 if you add a married couple standard deduction and exemptions), then withdraw Roth funds tax-free. Ideally, I’ll pay little or no tax with this strategy. If all you have are Roth funds, you are missing out on a current deduction for that $18,700 that won’t be taxed in the future anyway.

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This is a good post… I’ve been thinking about converting some of my Rollover IRA but this post gave me more food for thought. I guess at the end of the day, I think tax diversification is very important. I want to have several different types of tax-advantaged accounts because we never know what tax rates will be like in the future.

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My Roth posts:
http://www.joetaxpayer.com/roth-mania/
http://www.goodfinancialcents.com/roth-ira-amounts-maximize-wealthy/
http://www.biblemoneymatters.com/2009/09/what-is-a-roth-ira-and-what-are-the-benefits.html

And the comment I’ve left on a couple other blogs:
If one retired today, no pension, no other income, it would take over $2M to fill the 15% bracket. As inflation impacts the tax brackets themselves, along with the standard deduction and exemption amounts, it’s not fair to say that since one sees $3M in their account in 30 years that puts them in a higher bracket. Looking forward you’d have to adjust for inflation. If people who are now in the 15% bracket wish to save in a Roth or convert to ‘top off’ that 15% bracket, I have little objection, but those the ‘10 law applies to (earning $100K) are the very people who shouldn’t be using Roth in the first place.

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@Kevin@OutOfYourRut

I agree. I don’t look at it as retirement. Just the day you can say I don’t have to work if I don’t want to! To me retirement = death!
.-= Investor Junkie´s last blog ..What is a Master Limited Partnership (MLP)? =-.

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Nice post. I like how you spell it out in plain English because frankly, this is one dull topic that gets duller when I read the posts elsewhere.

Joe, your posts are a little too technical for dummies like me.
.-= The Genius´s last blog ..Private gift supports Antarctic research =-.

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I do have a Roth. And a regular IRA. To be honest, I never even came at it from the angle that we’re paying for bad government now.
I still don’t know why investments are taxed. How many times can they bleed me?
.-= Matt S.´s last blog ..Connecting with Favorite Authors through the Internet =-.

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@The Genius

Understood. No argument from me, I’m working on it. I guess your name is meant a bit ironically.
.-= JoeTaxpayer´s last blog ..More on Estate Planning =-.

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@admin

Guess I failed at trying to play devil’s advocate… Was thinking along the lines of The Creature from Jekyl Island (apparently there’s an updated 2009 version out there) and that taxes were the doppleganger (sp?) of our fiat currency.

And talk about being kicked while you’re down. That increase in the programs you listed – I’m of little faith I’ll be getting 0.25 on the $1 when I “retire” (will also not be sitting idly).

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@Matt S.
The gov’t wll bleed you dry if you let them.

@JoeTaxpayer
Yes, irony indeed.
.-= The Genius´s last blog ..Private gift supports Antarctic research =-.

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@admin
FS – Here’s the best answer I can come up with on your question. Income = power, and no one ever wants to give up power. This is even more true of high earners. Once they stop working for money, it becomes a whole new ballgame, and that’s often when they start earning even more money.

It’s a dynamic that’s counterintuitive, but then that’s basically what high earners are, esp the super high earners. They get to a point where they’re not only making a lot of money, but they’re also making a difference. Does that make any sense?
.-= Kevin@OutOfYourRut´s last blog ..Restaurant Tipping – How Much and When? =-.

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@admin
FS – I agree with what you’re saying. I was challenging the assumption that we’ll be making less post 65 than pre 65. We tend to accept that notion as some sort of conventional wisdom, probably based on the history of waves of factory workers pitching it in for a full retirement.

Times are very different now, the profile of the average worker has changed dramatically, and the future is an ongoing dynamic. What is the investment disclaimer… past performance doesn’t guarantee future results. That’s the world we live in! That whole post WW2 generation thing and all of its assumptions is passing and being replaced by something new.
.-= Kevin@OutOfYourRut´s last blog ..Restaurant Tipping – How Much and When? =-.

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@admin

Let me spell out the 2010 numbers so it’s clear for readers:
For MFJ (married, filing joint) they get two exemptions, $3650 ea, plus a standard deduction, $11,400. This totals $18,700 that comes off the top, no tax due. To generate $18,700 using a 4% withdrawal rate, you’d need $467,500 in pretax accounts. The next $16,750 is taxed at 10%, this would take $418,750 in pretax accounts to produce each year. This totals $886,250 (a bit higher than the numbers from my 2009 post.)
So $886K and you’re still in the 10% bracket.
The 15% bracket is the next $51,250 of taxable income. $1,281,250 to generate.

Retire today with $2.17M in pretax accounts and you are still in the 15% bracket. The next dollar is taxed at 25%, but you’ve topped off the 15%. I have no doubt taxes are going up. Do your readers believe the current 15% rate payers, couples making $68,000 taxable will be impacted?

(Note – the oddity of how social security becomes taxable does impact, bringing the numbers down a bit. Already too dry for most of your readers.)
.-= JoeTaxpayer´s last blog ..More on Estate Planning =-.

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Let me ask this question to the captive audience:

I agree about not converting traditional IRAs or 401ks. What about adding to a Roth IRA over a traditional IRA? Does that make sense if you are high income earner?
.-= Investor Junkie´s last blog ..What is a Master Limited Partnership (MLP)? =-.

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@JoeTaxpayer

No I think this is explained very well! I think most people can understand this. No snooze fest for me at least ;-)
.-= Investor Junkie´s last blog ..What is a Master Limited Partnership (MLP)? =-.

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I do agree with you. You’re a real expert in this field. Thanks for sharing this important information!

John DeFlumeri Jr
.-= JOhn DeFlumeri Jr´s last blog ..Podcast* "Gasoline Prices Going Crazy Again!" =-.

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I wrote an article on Roth vs. Traditional a while back. The gist was that there wasn’t a slam dunk best choice – it was all situational.

http://www.observingcasually.com/roth-vs-401k/

Hehe … I also have a defined benefit pension :) My co-workers gripe about my employer’s decent-but-not-mind-blowing 401(k) match and completely ignore the fact that we have a rare DB pension.
.-= Kosmo @ The Casual Observer´s last blog ..Interview with Kelly Whalen of The Centsible Life =-.

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@Investor Junkie

If you are above the threshold for a pre-tax IRA, then no harm in doing Roth. If to do the Roth you need the two-step, depositing to the IRA non-deducted and converting, you need to be careful, if you have any pretax IRA, it all gets lumped and prorated in the conversion.
.-= JoeTaxpayer´s last blog ..More on Estate Planning =-.

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I thought about this problem when deciding on my 401K contributions. Then I decided that it’s too much for me to tangle with so I hedged the contributions. Half of my elected contributions go to pre tax and the other half to post-tax (roth) 401K. Now, realistically this creates a net balance towards post-tax part. Luckily my company match is pre-tax, so that moves the balance back making pre-tax 401K heavy. And them my own contribution to Roth IRA gets the needle back to the middle. It’s not a very accurate/mathematical way of doing things, I agree. But it was the easiest to implement. Depending on the size of your companies match one can adjust the strategy.

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I have a Roth that I got ages and ages ago b/c one of my previous employers didn’t offer a 401k plan. Now that I have 401k I have no interest in Roths and I’m glad I didn’t put too much in it

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I was going to explain my $18,700 exemption from a previous comment, but it looks like JoeTaxpayer beat me to it. Nicely done.

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admin :
@Jesse

If the US is going to disappear in 30 years, we’re all screwed. So, let’s assume the US does disappear, why on earth would you pay MORE of your money in taxes if it’s going to disappear?

Interesting assumption, Sam. I think you may be betting on the wrong horse with that assumption, though ;)

Assuming that the US will be around for my entire life (reasonable), I understand what you are saying about the working income being higher than the retirement income. However, I know my pay is going to increase. It has been every year. Perhaps when I get towards a more comfortable spot in my career and get towards my top earning years I will shift away from a Roth (afterall, my taxes can only go down from there, I would assume). But while I am in lower brackets than I expect to be in 5-10 years, I think it makes sense to utilize a Roth.

Maybe not. Maybe I’ll take a day to run all of the possible scenarios.
.-= MLR´s last blog ..Who’s Afraid of the Big Bad Rebate? =-.

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Hey Samurai, those are some great points that you’ve made. It’s really refreshing to hear the other side of the Roth versus Traditional argument.

That being said there are a lot of valid reasons why someone may want to convert their Traditional IRA to a Roth IRA in 2010.

1. Roth IRA’s do not have a mandatory distribution at 70.5 like the Traditional IRA does
2. Principal contributions may be withdrawn at any time.
3. The liability for the tax paid at conversion can be spread over two years: 2011 & 2012

Here are supporting arguments for each point:

1. Because the Roth IRA does not have a mandatory distribution like a Traditional IRA does, the conversion makes sense for people who want additional tax-free growth past the age of 70.5. For example, if you’re wealthy and plan on passing the assets in your IRA to your heirs rather than making withdrawals at retirement, this makes a lot of sense.

2. Contributions of principal can be withdrawn at any time in a Roth IRA without penalty unlike the Traditional IRA. For those people who were planning on tapping their Traditional IRA due to tough times or are planning to use their Roth IRA as their emergency fund, the conversion makes sense.

3. The tax liability for conversion can be spread over the next two tax years; for those who were planning a conversion due to points #1 and #2, it’s better to delay the payment of your liabilities as long as you can.

As you mentioned in your post “whether you pay taxes now and let your investment grow tax free, or you let your pre-tax investments grow, and then tax it upon retirement results is more or less the same!” So if you get the benefits of points #1 and #2, why shouldn’t you do the conversion? Am I missing something?

Big fan of your blog, by the way.

Mike

@admin
.-= Mike´s last blog ..5 Reasons to Subscribe =-.

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@Mike

To address these points.
1. But to what end? As I showed, there’s a cost to convert and for most, a 10 or 15% tax upon withdrawal. If those RMDs are destined to be taxed at this low rate, what does it matter that the withdrawal is required?
2. Hmm. Those with a lot of money are less concerned about this. So I’d agree, that if you are in the low enough income level that this appeals to you, you probably are a Roth candidate.
3. But at what rate?

For all three of your points, I can offer (contrive?) scenarios where this supports your position or takes the opposite view. But it all starts with understanding more about each person’s finances.
.-= JoeTaxpayer´s last blog ..More on Estate Planning =-.

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@JoeTaxpayer

Joe, I completely agree with you that there are both scenarios where the 2010 conversion is a great deal and other scenarios where it doesn’t make sense.

Regarding mandatory distributions, it absolutely matters when they’re withdrawn! You’re right that distributions are “destined to be taxed” at the same low rate but the difference between paying those taxes now and 20 years later is a very big deal. Time value of money?

@admin

I’ll be honest with you. I’m not a real ninja.

As a matter of fact, I don’t know the first thing about ninja-samurai etiquette. But, if you say we can’t be friends, then we must battle to the death (If television has taught me anything, I know ninjas and samurais do that)!! But really, I’m not good at fighting; I’m a consultant for goodness sake!

Anyway, back to the discussion… the required minimum distributions of a traditional IRA and the option to withdraw principal are two different things and don’t cancel each other out. The implication is:

1. I have the option to have all of my principal and earnings continue its tax-free growth past 70.5 in my Roth IRA indefinitely. I don’t have that option with the Traditional IRA.

2. I have the option to withdraw any or all of contributions to my Roth IRA at any time in my entire life without penalty. I don’t get that option with the Traditional IRA until age 59.

The way I see it is with the Roth you have the option to continue investing (earning) past 70.5 and the option to withdraw at any time if you have an emergency (emergency fund). I’m on the same page as you when you say that you shouldn’t touch your retirement assets but if studying finance has taught me anything – the option to do anything is always worth something.

Thanks for letting me know about the comments… Did I accidently send that post through 5 times? Can you let that I’m passionate about the topic? Haha..

GREAT POST!
.-= Mike´s last blog ..5 Reasons to Subscribe =-.

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admin Reply:
January 12th, 2010 at 2:33 pm

Hi Mike – Yes, do some research on Ninjas in Japanese folkllore. Ninja’s are deceptive warriors and are oftened accompanied with the phrase “Ninja Assasin” if that gives you any clue. Ninja is also called “Shinobi”, and are often times spies. Ninja’s descended from a demon that was half man, half crow, and evolved to oppose the “upper-class contemporaries” (Samurais) in feudal Japan.

Ninjutsu, is the art of stealth. If a Ninja was honorable, there would be no need for stealth!

Ninjutsu versus Bushido:
Ninjutsu developed as an opposing force to the samurai code of bushido.

Samurai valued loyalty and honor above all else.

Going into battle, a samurai would select a single opponent, announce his challenge, list his family pedigree, and then attack. Samurai wore bright colors on their armor to announce their clan identity.

Bushido was very noble, but it couldn’t always get the job done.

That is where ninjutsu came in: the ninja code valued accomplishing a mission by whatever means necessary. Sneak attacks, poison, seduction and spying were all shameful to the samurai, but fair play by the rules of the ninja.

Thanks for being honest and telling us you aren’t a real ninja!

On to your points, yes, having an option has a value, but the value is what is questioned if you already have your emergency after 20-45 years of savings. The government WANTS you to keep your money growing tax free past 70.5 and never touch your money. That way, fund managers can earn fees off you, and perhaps you’ll pass away after age 70.5 and never get to realize your money. I surely hope nobody withdraws from their traditional IRA before age 59, otherwise, what’s the point of contributing in the first place? That would be dishonorable.

Yes, your comment posted 3X. It’s cool, but that’s what I expect from a Ninja! :)

Best, Sam-urai

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I think you should win some kind of prize for coining “hogwash donkey dumb”. Haha!
.-= Mike´s last blog ..5 Reasons to Subscribe =-.

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@Mike

Commutative property of math?

(Little Money * .75) * 10 = (Little Money * 10) * .75

The 10 is growth over say 20 years, but it doesn’t matter, 2X 10X.
All that matters is the rate. If it’s the same, it’s the same. If different, well, it can be big either way.
.-= JoeTaxpayer´s last blog ..More on Estate Planning =-.

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It looks like there are a lot of young folks who are discovering this post, defending their justification for doing a ROTH. Having a ROTH isn’t bad… I don’t think this is a case of bad vs. good. This is a case of good vs. less good.

MLR, your thought process is off regarding your tax comparisons like Sam-san said. Mike, good points on option value, but only the weak think about giving up and withdrawing money from their retirement fund.
.-= The Genius´s last blog ..Stock, students enjoy ‘reel’ relationship with Cuban filmmakers =-.

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@admin
Fact:
1. Ninjas are mammals
2. Ninjas are totally awesome

You should check out http://www.realultimatepower.net/ if you have some time and want a laugh. It seems like you a pretty good sense of humor. Haha.

And, I can’t believe you just gave me the entire history of ninjas and samurais in a comment. You my friend, are awesome. Haha.

But…. back to your point: there is no conspiracy between the government and fund managers. The IRS doesn’t want us to withdraw our funds so that fund managers can make more fees off of us? I just don’t believe that. What the government wants is to not have a bunch of homeless elderly people living on the streets (think US Recession of 1980′s).
“Between 1980 and 1993, the total number of older households in the United States –that is, households headed by someone over the age of 65 — increased by 31% (Gaberlavage and Sloan, 1997). ”
This is the reason why tax advantaged retirement accounts were created in the first place – to encourage saving for retirement. Not to mention, you don’t even have to invest in mutual funds with your Roth IRA anyway.

To both your and @TheGenius’ point about not withdrawing money from a retirement fund: it’s really dumb to withdraw money from your retirement fund – agreed. It’s even dumber if you take a penalty to withdraw that money.
But sometimes there are circumstances beyond all of our control (emergency, anyone?) where we need money and there isn’t any other way to get it. I think we’re lucky that nothing so terrible ever happened to us that we ever needed to do it. But I wouldn’t demonize the person who had to.

That sounds a little honorable, doesn’t it? Haha.

@JoeTaxpayer
Hey Joe, Sorry if my comment earlier seemed a little stand-off’ish.
I’m not sure what you meant in your above comment. Is the .75 supposed to represent a 25% tax rate and then the 10 is the amount of growth?

If so, here’s why that relationship doesn’t always hold for Traditional v Roth IRA

You say that ($ *.75)*10 = ($*10)*.75
or Roth = Traditional

While this holds true most of the time, when this doesn’t hold true is when you plug in the limit for the Roth IRA number. For example, you can contribute $5000 in 2009 to your IRA, right?
But, $5,000 to a Roth IRA is worth more than $5,000 to a Traditional IRA.
If you think about it, you’re essentially contributing more money when you contribute an equal amount to a Roth IRA since the contributions are made with after-tax dollars, right?
So a $5,000 Roth IRA contribution is equivalent to a $6,667 Traditional IRA contribution.

I think we can agree on a few points here:

1. Investing in both Roth and Traditional IRA’s are good because they’re both tax advantaged accounts.
2. A $5000 Roth IRA contribution is worth more than a $5000 Traditional IRA contribution
3. There is a $5000 limit for 2009, 2010 – there will always be a limit.

So, you can contribute more money to tax advantaged accounts if you contribute to a Roth IRA account.

Plus, a person with a Traditional IRA would have to invest his tax savings from contributions into an investment account that beats the tax-free return of a Roth. And since you can basically invest in anything with a Roth IRA account, it’s near to impossible.
.-= Mike´s last blog ..5 Reasons to Subscribe =-.

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Goodness me with the Ninja vs. Samurai debate!

But Sam, after your thesis, you’ve convinced me that I would rather be a ninja. Stealth, spy, seduction, the underdog, efficient attack; they all sound sexy to me.
What’s so sexy about long boring speech on your family pedigree? :D
Yeah, yeah, I might change my mind when I get older, later… way later.

Talking about getting old, enlighten me, in math term, is this (the discussion) about paying $20 now vs. paying $20 later (present value vs. future value)?
If there is no lower tax incentive when you retire (ie. retirees have the same tax structure as the rest of the population), it is only beneficial that you do this ROTH IRA thing when your income is very low now. You’re correct.

On the other hand, I also agree with Ninja Mike that the flexibility of being able to withdraw it anytime is definitely a plus point. That is the reason why I stopped making extra contribution to my retirement fund. Here, the employers are required to make 9% contribution and any extra contribution from me is tax free now but will be taxed for 15% when I retire. The money is locked until I’m 64 and who knows whether I’m going to live that long. So I’d rather put my extra money in a fluid investment now.

That being said, what is the extra benefit of ROTH IRA compared to other normal mutual fund (if your income level is average or better and flexibility is what you’re after)?
Anyway, that’s a 5 cents’ worth from a curious foreigner.
.-= Bytta @151 Days Off´s last blog ..Day 6: Four Reasons I’m Not A Diva (And Neither Are You) =-.

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I agree with you about the government just wanting out money and being smarter than we think, but I also think you are going over the top about how it’s better not to go with a Roth. I think different people have different situations and therefore some should open a roth while others a tradition IRA.

What I tell all my readers at http://financialsecrets101.com is that the most important thing is that they invest- PERIOD! People get too caught up in what to invest in, that they forget to invest on a automatic basis and just leave it alone. It’s not worth wasting your life trying to save pennies here and there.

Anywho, those are my thoughts. Thanks for the post. I like your style!

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Wow lots to think about here. Great post and great comments. Thanks for presenting a sound argument!
.-= 20smoney´s last blog ..Boost Your “Yield” By Writing Covered Calls =-.

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@Griff

You are correct for someone who is just starting, just invest. The thing is when have a decent sized net worth taxes can dramatically suck the life out your investments. We aren’t talking about pennies either.
.-= Investor Junkie´s last blog ..What is a Master Limited Partnership (MLP)? =-.

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An excellent and informative post, as always, FS. Let me attempt, in my preferred role as Devil’s Advocate, to rebut your rebuttals:

1) Let’s be honest, if we’re going to get out of the financial hole we are in as a country, we’re going to need higher taxes, less government spending, increased inflation or a combination of the three. Perhaps you’re right, perhaps Obama can’t raise taxes much beyond where they are now, but other politicians following him, starting from a higher level of taxation, can continue to slowly ramp up the tax brackets. (Let’s be honest, tax levels have been higher in the past, without causing the country’s economy to collapse; unless you have access to some detailed psychological research you’re not sharing, the idea that anymore than a 5-10 increase in tax rates (which, if I’m not mistaken, is only effective on the highest tax brackets, anyway) will cause the bulk of the country to say, ‘Screw it, it’s not worth working anymore’ seems far fetched).

Now, I’ll admit, I have no idea where Uncle Sam’s taxing hand will fall hardest in the future. Perhaps tax rates will be lower than they are now, making a traditional IRA a better deal. Maybe ordinary tax rates will be much higher than they are now (which is what many of those recommending these conversions are counting on), giving Roth accounts an edge. And of course, if we go from an income based tax system to a spending tax or VAT tax, all bets are off about how retirement accounts will be affected. Short of a time machine to see what the tax system looks like between when we retire and when we die (assuming we do eventually die and aren’t turned into immortal cyborgs or something), the best we can do is try to diversify to ensure that we’re ready for many eventualities.

(Side note: This conversion limit cap removal plan was put into effect in 2006, when, as you’ll recall, we had Bush Jr. in the White House and Republicans controlled the Congress. Now, Obama and team do stand to benefit from the timing of all this, I’m not denying that, but if anyone was trying to get people to voluntarily increase the amount they (the taxpayers) were paying in taxes to cover their (the politicians’) deficit spending, it’s the Right side of the aisle. Just to set the record straight.)

2) I honestly never heard anyone espousing the idea that they (or I) would be earning (or rather, pulling from retirement or other accounts) more in retirement than while working; in fact, I thought the commonly cited figure was 80% of your final income. Again, this seems to be related to the whole idea that taxes will rise in the future, making Roths seem more attractive (although again, we don’t know for certain what will happen in the future, tax-wise, so….diversify!)

3) Again, I’ve never heard that one before; paying taxes upfront would seem to have no effect on investment performance. But again, it comes back to the expectation that in the future, tax rates are going to be higher than they are currently. If it is, then Roth accounts are better; if it’s lower, then traditional accounts will be more profitable. If they do remain exactly the same, which is the only scenario I’d guarantee won’t happen if we’re looking at decades down the road, then it doesn’t really matter; but again, what’s the chance of politicians not messing with taxes between now and 2047 (when I turn 65)? (And of course, the same holds true for state income tax levels, as well; who’s to say that when retirement rolls around, there will still be states that charge no income tax for you to retire in?)

Don’t get me wrong, I do see your points, both about not paying taxes before you have to and about how much you need to save in order to generate your current level of income. Again, the best thing to do seems to be to diversify your retirement funds, holding a mix of traditional and Roth accounts (as well as a taxable account or two, in case they end benefiting from future changes more than the retirement accounts). I’m just saying, maybe the zombies have a reason for making this particular suggestion, one that is unrelated to doing Obama’s dirty work of boosting tax income.
.-= Roger´s last blog ..Small Business 101: Useful Skills to Have =-.

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Wow!!. This is a really great website. I am not as well versed in finances as your other commentors as I am really just trying to soak up as much info as I can. I learn something new everytime I visit. Even the comments are informative. Being able to view both sides of an argument really helps me make informed decisions. Great job.

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I find it extraordinary that you try to frame this as Obama’s idea when it was actually passed as part of the 2003 Bush Tax cuts (or the 2006(?) extension? I’m not sure which). Anyway, I really find it sad that in your first point you try to play politics in this and don’t even give a consideration to the fact that this has nothing to do with the current administration. I’ve never seen a financial equation that took into account which administration passed a law anyway.

I think you’re making the wrong comparison however. I agree with you that converting from a deductible IRA to a Roth is only good if tax rates go up drastically in the future (although with the deficit doing what it’s done in the last, oh, 20 years or so), that’s not impossible.

But the *real* use it not for people who have access to deductible IRAs, its for people who have yet-so-far been above the Roth limits and may have contributed to non-deductible IRAs. If this is your situation, then conversion to a Roth IRA gives you relatively little taxes to pay now, and gives you all the benefits of a Roth in perpetuity.

Finally, there are other benefits of Roth’s that you haven’t even scratched the surface on. Assuming you have a 401K, having a Roth also will allow you to chose the source of your income, and optimize your tax situation. It also may allow you to retire earlier by giving you tax & penalty free access to your contributions.

You are correct that some of the arguments you refute are very possibly inaccurate, but you miss a lot of others that are quite accurate.

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admin Reply:
January 15th, 2010 at 1:23 pm

Fredct – You shouldn’t have to defend Obama, because the post is not an attack on Obama. It’s the criticism of American GOVERNMENT policy, regardless of who is in office.

I’m happy you think you will have multi-millions when you retire in capital that will equate to more than your formidable earnings years of age 30-60, but others aren’t as fortunate.

The people of America are happy that you want to pay more taxes, because someone has to pay for the government’s spending binge, that someone should be the person who is benefitting the most, which sounds like you.

Best, Sam

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admin :
@Roger
Ah, Roger, the great policy geniuses have captured your mind, and I’m sad I’ve done very little to change the way you think.
At least you are contributing to your retirement. That’s the most important thing. The gov’t and the people of America thank you for paying more taxes than you have to, to fund our ways. In fact, part of your extra tax donations to the government is going to help reward big bonuses to the bailed out executives of AIG. Goodness bless America!
admin´s last blog ..Samurai Predictions And Resolutions For 2010

On the contrary, you’ve done quite a lot to change the way I think; you, the responses to this message, and my own research in attempting to argue my point, all have given me a new perspective. While before I would have been whole-heartedly in favor of Roth accounts, I do see that traditional accounts have their advantages, and I’m actually planning not to convert my own (fairly small) traditional account into a Roth, as a result.

What you haven’t done, however, is convince me that (a) future tax rates will not be a major determinant of which type of account will be better and (b) future tax rates will not be higher. Let’s look at your proposed deal with us, giving you 25-30% percent of our money now, with the promise that you would pay it back in 20-40 years. If we want to make it really representative of choosing between conversion or not, let’s make this bet instead: I’ll give you 25% (my 2010 marginal tax bracket) of my traditional IRA money now, but when I retire, you have to give me the current prevailing marginal rate on the amount my account would have grown (less the current tax, if any leveled on Roth withdrawals).

I’ve a got a little over $1000 in my traditional account now; that’s $250 I’d owe you now. My somewhat reduced nest egg ($750) grows over time, safe in a Roth account, to about $6866 by 2047 (assuming a 6% rate of return). If I had kept the money in a traditional IRA, $1000 would grow to be $9154 in 2047 at 6 percent. If there’s still a 25% marginal rate of taxation on money pulled from a traditional account (and a 0% rate on Roths), you’ll owe me $9154*(25%-0%)=$2288, exactly the difference between the value of the traditional account and the Roth account. Assuming tax rates are the same when we start our accounts as when we end them, we’ll have the same amount in after tax money to spend regardless of whether we use a Roth or a traditional account. Assuming you invested the $250 I gave at the same rate I invested the rest of my money, you’ll be able to pay me back with just those proceeds, leaving you with a net of $0.

But let’s say the marginal tax rate I pay rises to 50%, through a combination of my increased earning potential and higher marginal tax brackets while Roths are still untaxed. Now, you’ll owe me $9154*(50%-0%)=$4596. Suddenly, I’m sitting much prettier with my untaxed Roth, and you owe more than you could get by investing my $250. In this case, I win; by using a Roth and paying taxes up front, I’d end up with more after-tax retirement spending money than by using a traditional account.

Of course, I might not be the victor; if the marginal tax rate falls (let’s say your hope for a flat tax of 15% comes true), then the amount you owe me drops: $9154*(15%-0%)=$1373; I would have been better off keeping the $250 and investing it, then paying the taxes on it. Even worse, for my situation would be if Roths were being taxed at the same percentage as traditional accounts; whether that’s the marginal tax rate (if Roths lose their tax-free withdrawals) or at zero percentage (if we switch to a spending tax), the math works out the same: $9154*(25%-25% OR 0%-0%)=$0; I’ll have given up my $250 without getting any benefit. The point being, how good a deal such a switch is depends on future tax rates compared to current ones.

(You might ask why you don’t merely abscond with the money during the 37 years it will take to conclude our bet (or equivalently, what makes me think that the government will keep its promises years, or even decades from now). In the case of our bet, I’d have to depend on your samurai honor to ensure that I’d get an appropriate settlement when our bet concludes. ;) For the government, there’s more tangible reasons to expect that they’ll keep their promises: the government is controlled by politicians, politicians who want to be re-elected. You think that raising taxes beyond 5-10% will cause people to revolt and the government to collapse; I think that breaking their word regarding retirement accounts and how they will be taxed will be even worse. Greed is a powerful motivator for politicians, but fear is even more motivational ;) ).
.-= Roger´s last blog ..Fifteen Things to Tell A Younger Me =-.

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admin Reply:
January 15th, 2010 at 2:21 pm

Roger – Glad you are thinking things through more! That makes me happy. :)

Yes, I will take your money now, and promise to pay your taxes when you retire in 37 years. As JoeTP and Kevin pointed out, $2 million in capital is taxed at a 15% rate due to the deductions. I really do hope you have much more than $2 million in assets…. closer to $4 million to start paying a blended tax rate of 25%, I really do.

But for now, I will use your $250 to buy myself some new shoes, take my wife out to a steak dinner, and maybe buy some new tennis grip! This is what’s needed to stimulate the economy (this is what the gov’t is doing). I promise to pay you back in 37 years.

Best, Sam

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@Roger

Roger, maybe this will help. My deposit to my 401(k) are taken out at 28%. As they are taken off top like that strange film that forms on pudding, the entire deposit is skimmed at 28%. This is a fact. The known known, which I know, now.

As I stated further up (and to Genius’ point, this topic is dry, and very Ben Steinish, I know that) at retirement, if it were today, the first $11,400 comes out at zero. Now, this is a fact, too. You are welcome to think what you will about future tax structures, and I won’t criticize your prognostication, or even disagree. You just need to first really understand marginal rates that get passed through first before hitting the current bracket. Again, look at current rates and shift by a full bracket, so you can assume that 25% cutoff today is the 15% cutoff at your own retirement. You’d still need $1.3M in today’s dollar to fill that 25% bracket (I took the big shift into account).

The bottom line is that dollars today come off the top at the marginal rate, dollars at retirement start getting taxed at zero, first filling a huge tax bucket before getting to current level. Does this help illustrate the issue?
.-= JoeTaxpayer´s last blog ..Your Money Ratios =-.

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Its funny, Sam, because I didn’t say a single on of those things. And I myself will not be converting anything. I even agreed with you that most people shouldn’t. If you’d care to discuss my actual comments, I will be more than happy to do so.

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admin Reply:
January 15th, 2010 at 3:29 pm

fredct – You have an interesting way of agreeing with me, which is fine. Feel free to share with us a couple benefits of the Roth which I haven’t scrathced the surface of. The comment thread has been a long one, and we’ve learned a lot, so please share.

I know it may seem like I enjoy criticizing Obama, but whether it’s Obama or Bush in office, they will get the same wary critcism, b/c it’s important to fight for the people, whose tax dollars are hard at work doing something.

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Then why is it bad to provide the tax payer with additional options? No one is forcing anyone to do anything, but for those who is does make sense (and there are plenty of situations where it makes a lot of sense), they now have a new option if it makes sense for them.

I already did provide you a couple benefits (literally… I provided you with two, which is the definition of a couple) of having a Roth. But I will gladly repeat them again. First, I pointed out that having a Roth allows you to have more flexibility in retirement to control your taxes. Specifically, since the Roth money is tax free, it allows you to pull pre-tax money to fill up the low rate brackets and then use Roth money to avoid the higher brackets. A very useless technique that is only fully available to those with Roths.

Second, I mentioned that since your Roth contributions are withdraw-able without taxes or penalties at any age, you can retire early and begin living off of your Roth money before you reach age 59 1/2.

And, just for fun, I’ll throw a third out there… Roth’s have no required minimum distributions, so it allows you to have more control over when and how you use the money later on.

If you are in a position where those are particular important to you, or, for a variety of reasons, your conversion taxes would be lower than for most people, then a conversion *may* be a good idea for you. Not for most people, but for many.

And again, no one is being forced to do anything, but I don’t see how giving them a choice is something you need to oppose in order to “fight for the people”.

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admin Reply:
January 15th, 2010 at 7:21 pm

fredct – I guess we were hoping for something new. All your points have been mentioned in thread already. But, thanks for sharing!

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@JoeTaxpayer: I do actually understand the concept of marginal tax rates,although I overly simplified my response to FS for the purposes of illustrating a more appropriate bet. To be truly fair, I should compare the marginal tax rate (for a Roth) to the average tax rate (for the traditional account), taking the income paid in each tax bracket into account to determine the percentage and overall amount paid into the system.

Although, then things start to get complicated. Things like pensions will shrink the amount you can withdraw before paying higher amounts in taxes. I’m not even going to try to calculate just how all of that would affect the relative amount paid in taxes (and the after tax amounts) in each type of account; there’s just way too many unknowns to say anything for certain. And of course, I’m looking at thirty some odd years before reaching retirement age (assuming that the retirement age stays the same, yet another unknown), so who knows what the tax system will look like then.

@FS: I was attempting to reach $5 million in assets (if not more) actually, so $4 million should be easy (although, with our normal qualification that we can only guess what the tax system will look like in 2047). I’ve been trying to save somewhere in the neighborhood of 20%, with the understanding that when I settle down with Sondra to start a family, it might not be possible (plus, compound interest rocks!).

If you are seriously willing to bet, we’ll need to discuss the details and terms of the bet. What basis for gains we’re using, the methods of verification, the techniques of transferring the money, etc. Drop me an email at theamateurfinancier [at] gmail [dot] com so we can work it all out.
.-= Roger´s last blog ..Fifteen Things to Tell A Younger Me =-.

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@Roger

You make excellent points. Which is why this is not a black and white situation. Do you work for a company with a traditional pension? If so, and you plan to stay, this needs to be part of your planning. If not, then this applies to others fortunate enough to have one.

Your target is $5M? 27 years out. At 3%, money doubles in 24 years, so that’s a factor of 2. In today’s dollars, you are aiming for about $2.3M. Now, this is an amount that would just put you into the 25% bracket. If you were asking my advice (I know you’re not, really) I’d suggest you bide your time, and get closer to the end game. You’ll know if you’re on track to exceed your number or not. You’ll have the chance to convert in any year that you drop back into the 15% bracket for whatever reason. You’ll have over $1M in today’s dollars some 15-20 years from now, and if, heaven forbid, you become disabled, can withdraw those funds and stay at 15%.

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FS) I guess you’d make the same argument for Traditional 401ks -vs- Roth 401ks — that the majority of people should stay in the Traditional 401k. For me, my company match is considered a traditional 401k contribution, and I put all of my own contributions into the Roth 401k side. I call it hedging my bets.

Nobody has a crystal ball, but when we are currently living in an age of historically low income taxes, my feeling is that they can only go up. I’d rather pay the devil I know, than the one I don’t. Another huge plus going for me and my Roth-401k is that I have children and other types of credits and deductions that I can make use of to lower my current tax obligations. When I am in retirement, I will not have any of these fancy credits/deductions — so all else being equal (even if the tax rates don’t change) — I’ll be paying more in retirement.

I say: for working families to absolutely use Roth vehicles (IRAs / 401ks).

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admin Reply:
January 18th, 2010 at 3:06 pm

BG – You used the write word, “Devil”. The Devil has you under his control, and he hopes to promise you savings in the future. The Devil wins by taking more of people’s money now. Once you give the Devil your money, good luck ever getting it back.

It is great that you will have $5million in capital when you retire to pay 25% tax based off a 4% return, but most people won’t be able to save that much to break even. Achieving 50X the a average household income of $100,000/yr household income has shown to be tough to do.

Best, Sam

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@admin
I’m not sure what you are getting at with those numbers.

All I’m saying is that, if my retirement income is identical to my working income today (not that far fetched — 93% probability), then I’m better off investing in a Roth because I have tax credits/deductions that I can take advantage of now while I can (children in the household, mortgage interest, etc) — which effectively lowers my tax rate _today_.

For example, if I’m in the 28% marginal tax bracket, and I have various credits/deductions that lowers my effective tax rate to 9% (today) — why would I want to defer taxes on any income if I can get away with a 9% effective tax rate right now? Pay the 9% devil today, instead of paying some unknown (and likely higher) devil in 40 years. For me, the Roth is a no-brainer.

Am I missing something?

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While I agree that the conversion isn’t for everyone, I wholeheartedly disagree with some of the arguments in this post.
1) The Roth Conversion Party this year has nothing to do with Obama, and was in fact created during the Bush administration. Others have already pointed this out. My understanding is that it was created as one of those accounting tricks to make the Bush tax cuts look like they would cost less money over time than they actually would. (Other tricks include having the cuts expire after a few years. Politicians use that trick all the time – that’s why they’re always having to have emergency votes to extend programs and tax rates for a few more years.)
2) You are absolutely wrong that tax rates can’t go any higher. They have been much, much higher in the past, and may be much higher in the future than they are now. I’m not going to argue that they must go up, but neither can you argue that they can’t.
3) The fact that this applies to people over $100k may very well mean they have enough assets at retirement to make conversion a good bet. Most of the people that only have $2MM would be people making less than 100k last year, and could have converted any time they want.

In conclusion, while in the end I agree that a Roth conversion may not be a good idea, I disagree with nearly every other point you make in your post/

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admin Reply:
January 19th, 2010 at 1:11 pm

Steve – Thanks for your thoughts. The post isn’t an attack on Obama, it is not even an attack. It’s to illustrate why the goverment (no matter what political party) is doing what they are doing. Of course tax rates go higher, but I don’t think they will increase more than the proposed 5-10% hike Obama is already going to implement next year.

$2 million? We’re talking $5 million in capital for those to pay 25% tax.. ie get to $5mil when you retire, and that’s break even.

The people of America, and gov’t salute you! :)

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