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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@Investor Junkie
To work, while not NEEDING to work is what I’m after. And also, I don’t think many folks retire and do nothing, they just retire from something and move on to another.
@JoeTaxpayer
Thanks for the lnks. I’ll check em out. I think GRS had a post too, and couple others. Whatever the case, I wanted to write in as plain English, clear and concise as possible this whole debate. Hope I’ve done so.
.-= admin´s last blog ..Creating A Masterpiece By Failing Forward =-.
@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)? =-.
My Roth posts:
https://www.joetaxpayer.com/roth-mania/
https://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.
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.
@Little House
I wish you the best in saving for retirement LH! Just got to go ahead and take the plunge. Your expenses WILL adjust to your lower monthly cash flow. Start with 5-10% contribution of monthly gross income, and see if you can inch it up to 15% over time. Hope this article helps you think about the negatives of ROTH. There’s a lot of confusion out there.
@JoeTaxpayer
Joe – Unfortunately, I did not get a chance to read your anti-ROTH commentary. Do you mind sending a link or guiding me to where I can read your perspective? I appreciate it, given you’re the tax man.
@Monevator
Thanks for your UK example. That’s a perfect example as to why we shouldn’t so blindly trust the gov’t to do the right thing with our tax dollars!
@Kevin@OutOfYourRut
Seems strange you would want to work more into retirement if you’ve made enough to retire in the first place. Yes, when you get to the SUPER high earners, where dividends are the majority of their income, I can see their retirement years out earn their working years. Otherwise, for the large majority of us, that’s simply not the case.
@Kevin M
Thanks for highlihting the $18,700 exemption! Do you have a link to highlight more about this? I certainly plan to spread my withdrawals out as long as possible, to stay under what this gov’t deems “rich” to save on taxes.
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.
@admin
In theory that would seem to be true, but in practice, high earners don’t think the way the working class does.
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.
Kevin – Wouldn’t high income earners retire earlier since they are high income earners in the first place?
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 =-.
@Kevin@OutOfYourRut
A very valid point about high income earners.
.-= Investor Junkie´s last blog ..What is a Master Limited Partnership (MLP)? =-.
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 =-.
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? =-.
@RC@Thinkyourwaytowealth
You’re right about the ability to use the ROTH to diversify your tax liability, b/c who knows what holds for us in the future. I’m willing to take my chances, and control my destiny by lowering my taxes by 10% in retirement by moving to Nevada.
Once you pay the money, you’ll never get it back. Diversifying your tax liability is fine, but it’s not worth it to me. I’d rather battle when the time comes, than claim defeat now.
@Minority Fortune
Thanks for reading! It’s worth sharing with others, because too many people just follow gov’t rules blindly.
@Matt Jabs
Nice Matt. I like your does of skepticism and realism!
@thriftygal
Hope your hubbie can read this post and give him a dose of thought. Don’t forget to send me your mailing address for the book. Congrats!
@Jesse
Jesse, the top marginal tax rate is going from 35% to 40% in 2011, that’s 5%. Add up the increase in SS/FICA/MEDICAIRE etc, the total marginal tax bill is going from 50% to 60% for many Americans fortunate enuff to be making that money.
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?
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)? =-.
@Craig
Craig, I’m being somewhat facetious about how smart the government is.. but in terms of legislation, and figuring out ways to spend like a maniac, and take money from the public, they are GENIUSES.
They rely on the zombie attitude to collect and spend from the masses. The question is NOT whether you will make more when you are 40, than when you are in your 20’s. The question is, whether you will make MORE in RETIREMENT when you have to pay taxes, than during your earnings years on average.
The answer is unlikely, sorry.
@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? =-.
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.
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 =-.
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 =-.
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!
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 =-.
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 =-.
@Moneyreasons
Thanks for your rebuttal. I just added more in the questions section below asking if anybody would like to pay more taxes up front, whether they can consider just giving it to me, b/c I promise their money will be there when they retire, even though the guy in charge won’t be :)
Giving the gov’t MORE of my income now is endorsing wasteful, budget busting spending. $2.7 TRILLION budget deficit for goodness sakes. Pork spending, lobbyists, interest groups. Not me, I will keep as much of my money as possible and move to Nevada and retire.
@David @ MBA briefs
Can’t argue with math is right. And I don’t understand after reading like 7 “pro ROTH conversions” why the writers don’t get it. Why, I donno. Advertisement dollars, and sponsors perhaps?
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 =-.
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 =-.
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 =-.
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 =-.
“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 =-.