Be A Sloth and Don’t ROTH – Why Converting To A ROTH Is A Mistake!

If I read one more biased article pushing people to convert to a ROTH IRA I’m going to lose it!  Not to be melodramatic or anything, but the lack of unbiased analysis is like seeing a sea of zombies instructed to walk off a cliff. Wake up zombies, wake up!  Don’t make a decision without seeing what lies down below.

The ROTH IRA conversion idea is that those who have pre-tax funded retirement accounts such as a 401K or Traditional IRA pay taxes UPFRONT, so as to not pay taxes when you retire.  This is just absolute hogwash donkey dumb for a large majority of people out there.

Proponents of the ROTH IRA conversion argue:

1) Tax rates are low and are just going to go up in the future.

2) You will likely make more money in your retirement years, and hence pay more taxes.

3) Paying taxes now improves performance in the long run all else being equal.

THE SAMURAI REBUTTAL:

1) The government is smarter than you.  They are geniuses at spending other people’s money, and extracting as much money from you! Despite so much red-tape, when it comes to fiscal and monetary policy, they’ve got geniuses running the show.  Sure, back in the 70′s and 80′s the absolute marginal tax rates were higher, but there were many more income levels of taxation, and if you calculate the inflation-adjusted income levels, we’re actually better off now!

Think about why the government introduced this wacky piece of legislation from the government’s point of view.  Obama and team are running a $2-3 trillion deficit.  How the heck are they going to fund their binge spending?  By introducing a new idea to be able to allow millions of people, and billions of dollars to be taxed right now to shore up their deficit!

They convince the masses that doing a ROTH IRA conversion is a GREAT IDEA, knowing in the back of their minds that taxes can’t go much higher than what Obama is proposing already.  Furthermore, the government gets people who make over $100,000/yr excited when they say “no income cap in terms of contribution and conversion”!  Another smart move so they can collect MORE tax dollars from the wealthier population now which already pay all taxes!

2) Love your enthusiasm that you think you’ll make more in your retirement years than in your prime 30-50 earning years.  But I just have one question.  Are you crazy? Let’s say you average $100,000 / year until you retire.  To replicate $100,000 in income, you will have to have at least 25X your income in capital, or $2.5 million at a 4% risk free return to produce $100,000/year!  The last time I checked, the best 5-yr CD’s now pay 2.5%, which means you need 40X your income, or US$4 million to produce $100,000 of income.  GOOD LUCK SUCKER!

Let’s say Social Security brings in $25,000 a year, to make $75,000 still requires you to have $1,875,000 to $3,000,000 in liquid assets at a risk free 4%-2.5% return.  When people are struggling to accumulate 10X their income in retirement savings, what makes you think you’ll be able to achieve 19-40X?

Let’s be realistic here guys. The only age group that might make sense are those in their 20′s, when their earnings power and therefore tax rate is still relatively low.  Then again, if you are earning a smaller amount, the absolute tax savings won’t be that important anyway.

3) The results are the same based on 2nd grade math. 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! Don’t believe me?  Do a calculation yourself.  Here’s an equation: Y = A * B.  Re-arrange to A = Y / B.  Or Y = A * B is equal to Y = B * A.  Trust me, I was a rock star in the 2nd grade!

CONCLUSION

Whenever something sounds too good to be true, it probably is. There is a reason why the government is offering this new “one time”, no income limit ROTH IRA conversion.  The reason is they need your money!  The government knows that they can’t possibly raise income taxes much further than the already 5-10% increase Obama proposes in 2011, 2012, and beyond, otherwise nobody would work, and capitalism would fall for good!

Lucky for you, you’re not a mindless zombie listening to everything the government and other sites tells you.  You realize there are seven no income tax states in America you can retire in, thereby immediately wiping away 5-10% of your taxable bill.  If you move to Hawaii, the state can’t legally tax your pension or retirement contribution!

It’s a good problem to have if you are making more in retirement than during your working life.  However, the facts reflect a high unlikelihood you will have have 20X-40X+ your income  in capital to draw from when the time comes.  And remember, 20X your income is just the BREAK EVEN amount in taxes you’ll have to pay, all else being equal.  You need to have 30X+ your income as capital for a ROTH IRA conversion to make sense at an interest rate return of 4%. Even if you do have 30X your income in your 401K, you can draw on the NUT at a much LOWER level to keep you in a lower tax bracket.

Never pay taxes unless you absolutely have to. Can you imagine when you’re about to retire, the government introduces new legislation which benefits Traditional IRA and 401K holders by offering LOWER tax rates?  Meanwhile, over the past 20-40 years, the government has been using your ROTH IRA conversion to spend on a party that one day needs to be repaid.  I’d be pissed.  Don’t let the government trick you into converting.  Once you pay them, you can NEVER get the money back.

Recommendations To Grow Your Wealth

1) Manage Your Finances In One Place: Get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts (brokerage, multiple banks, 401K, etc) to manage my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing and when my CDs are expiring. I can also see how much I’m spending every month. If you are interested, they can even provide tailored financial advice for much cheaper than traditional wealth managers.

2) Use E*Trade To Rollover Your IRA. I’ve been using E*Trade for the past 12 years and they are excellent. If you have switched jobs, consider rolling over your IRA. Open an E*TRADE Rollover IRA. No Fees. No minimums.

Keiju,

Sam @ Financial Samurai – “Slicing Through Money’s Mysteries”

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. BG says

    JoeTaxpayer) I understanding the math behind this better and agree with you (again) — for me, I appear to be better off with the majority of my investments in the traditional side. But what I don’t understand is the Roth IRA income caps & phaseouts.

    Roths are great for people who save a ton of money, and expect to have very large incomes in retirement. But to be able to save enough to guarantee the large retirement, you have to have a large income today — which precludes you from being able to invest in the Roth (a catch-22).

  2. shelter_island_mom says

    Joe – I didn’t read through all the comments, but hopefully someone pointed out some flaws in your logic. A ROTH conversion isn’t for everyone – no doubt about it. If someone can’t afford to do without taking money from their IRA – don’t do it!

    Conversions are reversible for those that change their mind. Taxes can be opted to be split over 2 years.

    The loophole that allows this conversion due to no limits in 2010 was prior to Obama’s administration. Don’t get me wrong – I think he’s a financial nightmare for this country.

    In our example -

    1. We have large tax deductions in the form of mortgage interest and dependents with child tax credits. When we are in retirement, we will not have any of those “write-offs” (if they even exist at that point.)

    2. Most all of our other retirement is pre-tax deductions through current employers. So it’s good to be diverse.

    3. ROTH Ira give additional flexibility with regard to withdrawals and payouts – for example: no RMD at age 70. So, we aren’t required to take the money if we don’t need it in any particular retirement year. Or, we can use some to help one kid through medical school, so he can support us down the road. (humor)….That alone is worth alot.

  3. Mike says

    Roths are only good for those people who are a long way away from retirement. If you are young (20′s or 30′s), a Roth is a good idea. If you are near retirement, not so good. Sorry for those of you who are near retirement, Roths came too late for you guys.

  4. Sandy @ yesiamcheap says

    It seems like a good debate is raging here. The fact is that I don’t expect to make anywhere near the numbers that Samurai and Joe Taxpayer are using for their assumption, but I still want to hedge my bets, so most of my money is in a traditional 401K and once I finish fighting with the state about some tax issues, I plan on starting a small (key word here) Roth IRA since I’m still pretty young.

  5. Buck says

    Logical and reasonable breakdown. Thanks for helping me look at this issue from another point of view. I think I was doing wishful thinking, “I will be making more later in life so I need to protect it and grow it tax free!” Government needs money now… Diabolical!

  6. Sunil from The Extra Money Blog says

    i actually believe the Roth is a good investment tool while one is eligible for it. i do recognize the potential downsides to it as highlighted in the post. i.e. the government can change laws/rules on taxation to make it more/less favorable at any point. i have bought and sold a few properties from within my Roth (on leverage), thereby legally avoiding taxation on the gains. i know this is not a “common” use of the Roth vehicle, but it has worked well for me.
    when i first started my Roth, I did it because I anticipated higher tax rates in the future, and retirement income near levels during the hay days. this post puts the tax situation in good perspective in that how much can income taxes go up after all? as far as income during retirement, i am not so much relying on a fixed income model from capital invested, but rather cash flow / income streams from various activities, some of which could be capital invested.

  7. krantcents says

    The threat is taxes will be higher! At least that is used in the Roth advertising! Your income may or may not be higher. My personal take on this is more pragmatic. It would cost me a ton of money to convert all my IRAs to a Roth! If my effective tax rate is higher in the future (retirement), I will find a way to reduce my taxes. One way is take less in withdrawals from my IRA. When I retire, I will have multiple streams of income such as Social Security (H & W), pension, IRA, Roth IRA, brokerage account and blog income.

    • Financial Samurai says

      That’s right. We will find a way to reduce our taxes. We can move, take deductions, do this and that. What we can’t do is pay our government MORE taxes so they can spend more on wasteful things. Ridiculous!

  8. rothswork says

    ok, a roth works for me because i took an early out pkge in 2009 and paid large tax bill. In 2010 and forward, i live on a decent pension, only 60 yrs old ==thus 2010 partial trfr from 401 to roth gets split taxed in 2011, 2012 at rates that are very low. in six years i get soc sec , drives me into next up bracket. i left some funds in 401. At 70, soc sec, pension plus spouse deferred pension drive me into higher bracket again, PLUS at 70 the MRD forces 401 withdrawal at my highest marginal rate. The roth has already been taxed at lower rates and should grow tax protected with no MRD at 70. thus the unique brackets i am managing give me the lowest tax cost position by using the roth conversion options. As for inheritance planning, my 401 gets hit as ordinary income but roth principle and all growth continues tax free to my heirs. thus a roth trfr can be beneficial but is dependent on each situation – and actually was very beneficial to a number of my friends who also found themselves with early exit payoffs and sizable 401 balances. At 70 i plan to do annual 401 to roth conversions equal to the inflation growth of the marginal tax bracket. Thus shifting possible ordinary income inheritance pool to tax free pass trhrough. Conclusion-> roths conversions can work very well.

  9. Richard Walters says

    Roth accounts are the only way to prevent your social security income from being taxed.
    so you will save money in taxes just not with your retirement account.

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