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.
Converting To A Roth IRA Is A Mistake
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 To Roth IRA Conversion
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.
Related: Disadvantages Of A Roth IRA: Not All Is What It Seems
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This article seems like a lot of hoopla without a lot of fact. Following a “Never pay taxes unless you absolutely have to” strategy will not guarantee you will come out ahead. It may sound good, but the fact is there are plenty of scenarios where you could come out ahead with a roth. And the formula transformations given (Y = A * B. Re-arrange to A = Y / B. Or Y = A * B is equal to Y = B * A) have absolutely nothing to do with the calculation of roth vs traditional gains. The logic given here is generally flawed in that the conclusions do not logically follow from the premisses. Also, as @Richard Walters states, taxable withdrawals can affect your social security income. It can effectively put you in tax brackets much higher than the ones posted by the IRS. See https://www.bogleheads.org/wiki/Taxation_of_Social_Security_benefits. In the end, deciding whether contributing to a roth depends on your situation. There is real math you can use to estimate which will most likely serve you better.
frank – excellent points and the reason it’s called Personal” finance. The social security taxation isn’t indexed for inflation, so more and more people will not be able to avoid the taxation the article discusses. When my wife and I are both collecting, the social security income with be enough to trigger the taxation. A no-win scenario.
But. For those who under that threshold, converting to Roth in the 10 years before collecting SS benefits might be a good idea. In fact, if one can retire at 62 or 63 thinking they’ll take the early, reduced benefit, they can come ahead by living off the retirement money, drawing it down, along with conversions, and letting the SS benefit grow to age 70.
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.
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.
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.
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!
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.
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!
Ha! Nice. Glad you find the post logical. Frankly, it is so logical with this huge deficit we have!
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.
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.
Eh… did you read the post? If you are young, the ROTH is the worst thing you can do.
I think I’ll stick to a SEP IRA. All this ROTH stuff is confusing.
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.
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).
@Ethan
If by ‘remove’, you mean as a variable, yes, this is true. Removing the variable doesn’t make it a good decision though.
You say “usually” 15%. If you use pretax to stay right at 15%, and Roth for any more savings, I’d not say it was a bad decision. But – the chance of you becoming disabled or unable to work for a time is real, greater than ‘zero.’ Your standard deduction and exemption would cover a nice annual tax free withdrawal were that the case. And that 15% tax you paid would be an error, in hindsight. At 25%, I’d not recommend converting to all but a select few.
.-= JoeTaxpayer´s last blog ..A Roth Roundup =-.
@Joe
I wasn’t trying to make an argument about inflation – I must have been unclear there. I was just referencing that your buying power in retirement depends on 1) contributions, 2) returns, 3) inflation and 4) taxation. And that you can largely remove one of those (taxation) from the equation with a Roth vehicle.
With my 75-year-old example, I was not referring to the situation in which a 75-year-old switches brackets, but the situation in which tax rates are increased by the government. In fact, the 75-year-old switching brackets is almost a non-issue by default. They obviously have other things going their way if they are moving *up* the bracket range. Even it means that their Roth/traditional decision wasn’t in retrospect quite as good/bad as they thought, they are obviously not hurting for it.
No, I meant to refer to taxes simply increasing while income does not. For myself, age 75 is 43 years away. That’s a long time to predict anything about taxation. But let’s say that today I pay 25% on my Roth contribution dollars, and at 65 I find myself only in the 15% tax bracket. This would be a classic example where people would say that I should have gone traditional. Fast-forward 10 years: everyone got a 3% tax hike. The traditional is still a net gain over a Roth, but when would I have realized that gain? During my working years. When would I have payed the price? During retirement. My buying power would have just dropped (by something less than 3% due to deductions, but not 0%) and I wouldn’t have been able to do anything about it. As a Roth user I am unaffected. And I’m unaffected by taxation changes at 85, 53 years from today. And I’m unaffected by taxation changes at 95, 63 years from today, if I happen to live that long.
I’m not saying you should pay 35% tax on Roth contributions today. Personally I usually fit into the 15% bracket, and I consider Roth’s a no-brainer at that level. But even at 25% I would recommend hedging your bets and putting half in a Roth and half in a traditional account.
But Ethan – the dollars used to pay the tax at retirement are also inflated, so to that point, it’s a wash.
The pro-Rothers keep referencing a mythical tax increase. Yet, to be in the 25% bracket today at retirement, one would need over $2M in today’s dollars.
So while you might be right about that 75 yr old you chose, he is in the top 5% of retirees. I can contrive a dozen scenarios where the traditional is better, but likewise a dozen where conversion is best. If in fact conversion is best for few than 10%, than why is 90% of the dialog promoting it? Why no warning about how few would benefit?
.-= JoeTaxpayer´s last blog ..A Roth Roundup =-.
Ooh, ooh pick me! I disgree! :) As I commented over on GoodFinancialCents:
I’d like to point out my favorite feature of all Roth vehicles: they reduce the number of variables affecting your buying power in retirement. Yes, tax-deferred *may* prove superior to tax-free for some people if you are looking at it purely from a dollars standpoint. But you don’t find out until you retire; in fact you only find out year-by-year *during* retirement. In addition to your buying power depending upon returns and inflation, it also depends on tax rates if it’s coming from a traditional account.
Imagine yourself at age 75. If your tax bracket increases that year, *even if the new rate is still lower than what you would have paid when you were making contributions*, the buying power generated by your traditional 401k distributions will decrease. Not so with distributions from a Roth vehicle. So it’s not just about which gives you more bang for your buck over the total time period, it is about whether or not you can count on your buying power once you no longer have the ability to alter it through earned income.
So maybe I pay 25% tax on Roth contributions this year, but this is my earning phase. I can handle it. I can pay more now, not to increase my total nest egg later, but to reduce the risks to my buying power later. The alternative is to *increase* the risks to my buying power in retirement, in return for saving money today. Does that sound like a good idea? Not to me. Inflation, returns and taxation are all significant variables which most of your retirement planning efforts will revolve around diminishing as far as possible. The opportunity to remove taxation from that list completely is too good to pass up.
(Note that it is only Federal income tax that Roth distributions avoid… they can still be subject to state income tax. But in many states no taxes would apply anyway, and at least it gives you the option of moving.)
@Benjamin Bloom
From 59-1/2-70-1/2 withdrawals are optional, not RMD.
RMDs are one factor. It starts at 3.6% and doesn’t get larger than 5% until age 79.
The ‘poor schmuck’ would be worse off had he paid the taxes on the larger, pre-recession value, no? Now his taxes due are less, not more. BTW, he ‘locks in’ nothing. You can take a distribution in kind, i.e. withdraw the stock not sell it and remove cash. The withdrawn stock takes on basis as of the date of transfer out of the IRA.
By the way, late 50’s is a great time to consider all this. Close enough to retirement to really have a grip on your pretax wealth numbers. I have an 80 year old. 15% bracket with some room to spare. For 5 years, now, we’ve been converting just enough to Roth each year to ‘fill the bracket.’ As her RMDs grow, that amount may be less each year, depending. For 2009, with no RMD we had a nice conversion number. I hope this exemplifies both my strategic use of Roth and my not ignoring RMDs.
.-= JoeTaxpayer´s last blog ..Frugal Friday Week 31 =-.
You are calculating effective average, not effective marginal, which is what I call Phantom Rate.
You want to understand the impact of just the last dollar added or taken away, as this would drive your choice between tax status of retirement accounts.
This can’t be gotten just by glancing at the tax form and dividing. You’d need to “what-if” by adding a dollar or really $100.
You may be in the lucky situation to be able to be in the 15% exactly over the next 10 or more years choosing between the two.
.-= JoeTaxpayer´s last blog ..Frugal Friday Week 31 =-.
We are fogetting one very important point in all these arguements.
RMD’s
To some people, this is what they are most afraid of in traditional qualified retirement plans. All of these types of savings vehicles have required minimum distributions. They must occur between 59 12 and 70 12.
Let’s say we have another recession when some poor schmuck reaches 70 and he is REQUIRED by the IRS to pull money out of his IRA, and then pay tax on it. He would effectively lock in huge losses, pay taxes on the reduced amount, and his retirement funds would be depleted even faster.
@JoeTaxpayer
Thanks Joe. I think there was a mis-communication. I’ve been talking about $100k gross income (line 7 of the 1040), not $100k taxable income (line 43 of the 1040) — I wish though :)
What you are calling the ‘phantom rate’, is what I’ve been calling the ‘effective rate’.
https://en.wikipedia.org/wiki/Tax_rate#Effective
“The effective rate of tax can often be discussed in terms of the effective marginal rate of tax – namely the amount of effective tax paid as a percentage of the last dollar earned or spent.”
I’ve been calculating the effective rate as: ER=TaxPaid/GrossIncome. Gross income being line 7 of the 1040. Looking at my 2009 filings, this equals 8.92%. If you are calculating it as ER=TaxPaid/TaxableIncome, where TaxableIncome is line 43 of the 1040, then the rate is 12.32% for me in 2009.
I think we are mind melding now.
Sam, please pass me the lectern. (Thanks, I was falling off the soap box and dropping my notes.)
BG – there are two things at play. Your marginal tax rate (15%/25%) and the “phantom rate” you might experience due to phaseouts. Phantom Rate is what I call the dollars paid in federal tax on the last $100 you are taxed on. I have no trademark on it, others call it something else.
“You can’t ask what the tax rate was on the last XX dollars”
Of course I can. Really. I go into TurboTax (where I am a guest blogger. I think they owe me lunch) and just before I print my tax return, I increase/decrease my income by $100. The degree to which my tax goes up or down answers that question.
I am sorry, I thought earlier on you stated you were in the 28% bracket. If your taxable income puts you in the 15% bracket, I’d suggest you use Roth and Roth conversion to the extent that it fills the 15% bracket, but doesn’t make you pay 25% on any income.
As you get to the point where you are in the 25% bracket, I’d use pretax accounts to keep you down to 15% with an eye on enough pre-tax money to fill the 15% bucket at retirement.
My understanding of your situation has changed. My view that average/effective rate as a red herring has not. It only serves to inject a data point useless for this analysis. If it gets you the right answer, it will have been for the wrong reason. Try to digest this, unfortunately, Vulcan mind meld not an option.
.-= JoeTaxpayer´s last blog ..Frugal Friday Week 31 =-.
Don’t think so. You are not taking into the massive effect that having two dependent children, plus claiming the Child-Tax-Credit gives me in my working years (currently). That amount is $3,917 right off of today’s tax bill. That amount off of the tax bill effectively knocks me out of the 28% (or 25%) marginal bracket, and actually puts me in the 15% marginal bracket today — down to an 8.2% effective tax rate.
This is an important point: Earning $100k a year, with two kids, is the tax equivalent of a couple with no kids earning $64k.
You can’t ask what the tax rate was on the last XX dollars, if you can’t yourself answer the question on which dollars are saving the $3,917 via the deductions/credits. The only solution is to work with the average / effective tax rates.
I do admit an error in my earlier post. If I invest $15k into a tax-deferred account today, then that would lower my taxes down to an effective rate of 5.3% right now (taxes on $85k gross income). That immediate savings in taxes would free up an extra $2,900 we could invest. I’ll need to run the numbers to see if that extra money, if invested, would cancel (or beat) the higher effective tax rate in retirement. You might be right about traditional -over- Roth, but for the wrong reasons…
I’ll work on those calculations this weekend and get back to you.
Thanks for the great discussions!