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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@admin
Fact:
1. Ninjas are mammals
2. Ninjas are totally awesome
You should check out 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 =-.
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 =-.
@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 =-.
I think you should win some kind of prize for coining “hogwash donkey dumb”. Haha!
.-= Mike´s last blog ..5 Reasons to Subscribe =-.
@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 =-.
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
For readers following this thread, RMD = Required Minimum Distributions. If I was 69, I’d for sure withdraw my money, b/c I’d be worried I’d die before enjoying it! Ya never know!
RMD Explained:
When you reach age 70½, the IRS requires you to withdraw at least a minimum amount each year from all your IRAs and retirement plans and pay ordinary income taxes on the taxable portion of your withdrawal.
Required minimum distributions (RMDs) ensure that the government collects the taxes it deferred all the years you were saving in a traditional IRA or your retirement plan. What do you do with the money once it’s withdrawn? That’s pretty much up to you and your individual needs. Just be sure to take at least the minimum withdrawal each year. When you do, you can:
Reinvest some or all of it in a taxable account.
Spend all of your money.
If you don’t take your RMD, you’ll owe a 50% federal penalty tax on the difference between the amount you withdrew and the amount you should have withdrawn. And you’ll still have to withdraw the required amount and pay any income tax due on the taxable amount.
@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 =-.
@Mike
Hey Mike! First of all, love the gravatar and your site’s theme. However, not sure if we can ever be friends since you are a Ninja, and I am a Samurai! lol.
Good positive arguments you make. Doesn’t your #1 and #2 kind of cancel out though?
Also very good reminder that the tax liability can be spread out over two years. Ah, so much complication, and what a pain in the bum for the masses though.
I believe in slicing your pools of money for maximum returns. The retirement money in your IRA, 401k, whatever should never ever be touched, unless you’re about to go bankrupt. Hence, wrt to your argument #2, although it’s a nice option to have, that’s what one’s savings account in their bank is for. No co-mingling of funds!
The overriding thesis of this post is that it is ludicrous to give more of your hard earned money to the government, when they are demonstrating irresponsible spending, while promising you that you will save money when you are old. The returns are roughly the same, but I believe for a large majority of people, they will NOT be making more money in retirement from their assets, than during their working lives. Hence, retirees will pay LESS taxes, so don’t be fooled.
Hope to see you around more often! Appreciate your analysis.
Best, Sam
ps it takes a while for the system to auto approve comments for new commenters. eventually, it will learn.
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 =-.
@MLR
Howdy MLR – the quote you took was my rebuttal to an assumption another made. Obviously the US will still be around in 30 years, although perhaps as a great socialist country as some may argue.
You’re making the wrong assumption on taxes. I certainly hope and expect you to make more as you move into your 30s, 40s, 50s. However, you need to compare the taxes rate you pay upon RETIREMENT vs. the tax rate you pay now, since between 30-50, the contributions to your traditonal IRA and ROTH are tax free.
Check out JoeTaxPayer’s reasoning above as well.
@ Kevin – Yep, JTP explained it well. Thanks for highlighting the exeption in the first place though!
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? =-.
I was going to explain my $18,700 exemption from a previous comment, but it looks like JoeTaxpayer beat me to it. Nicely done.
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
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.
@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 =-.
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.
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 =-.
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!" =-.
@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)? =-.
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)? =-.
Joe – That was a perfectly spelled out comment! Makes a lot of sense and easy to understand! Makes the conversion to a ROTH an even WORSE idea! $2 mil of capital in retirement getting taxed at onlky 15% is fantastic!
Everybody have a read of Joe’s comment above.
@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 =-.
@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? =-.
@BawldGuy
Bawld Guy – Love to hear your strategies on legal tax shelters for the common rich man under Obama’s definition of rich!
@Kevin@OutOfYourRut
I guess that makes sense. But, if you are a super high earner, non of this conversion stuff really matters, b/c you have hoards of money already to live happily ever after.
In this ROTH conversion example, would you consider someone making $500-$1million a high earner? I do, and I will tell them they are NUTS to conver to a ROTH now and pay taxes on their 401K and traditional IRA, which they prob don’t have much of b/c the contribution was capped at those making around $105,000 or less.
JoeTP provides some good color on capital levels in retirement ie $885,000 equating to 15% tax rate in the future. At any rate, the point is, don’t pay more taxes than you need, and best to you for believing you will have at least 20X your average annual income in your life when you retire!
@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? =-.
@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 =-.
@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).
@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 =-.
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 =-.
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 =-.