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The Year of the Roth


twacowfca

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This year all holders of US IRA's can convert a regular IRA into a Roth IRA.  Formerly, only relatively low income IRA holders could do this.  The big advantage of this conversion is that this enables the IRA holder ,defacto, to almost double the assets that will compound tax free in future years.  Why is this?  Because the state and federal governments in effect "own" about 45% of each regular IRA by the fact that you'll have to pay taxes on the mandatory distributions when you reach age 70 1/2. (I assume that all members of this board are going to be taxed at the highest current marginal rate when they retire).  Conversion now to a Roth IRA in this unique year of opportunity will in effect nearly double the tax free compounding stream that the IRA account holder actually "owns"!  :)

 

Of course, you'll have to pay taxes on the regular IRA assets when you convert to a Roth, so in a sense you'll not have the opportunity to compound what you'll give up in this tax payment.  Never the less, biting the bullet and paying the taxes now is still a great advantage.  If you hold on to this money that you'll have to pay for taxes, and then use it to invest outside of an IRA, you would then be taxed on your gains!  In effect, assets that would be taxed on future compounding are being transferred to an account where they won't be taxed!

 

What's this?  You say you don't have enough money to pay taxes on conversion of your regular IRA to a Roth IRA this year?  Not to worry.  :)  You are allowed to string out your tax payments on the conversion, making them in 2011 & 2012.  Don't delay. This offer probably will not be extended.

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Thanks for posting!

 

I didn't realize until reading your post that one can pay the IRA taxes with money outside the account. (I had wrongly assumed that the account assets would need to be liquidated to pay the tax).  Doubling the terminal value of this account makes the conversion a slam dunk decision.  The fact that you can defer the tax for a few years...even better!

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Guest ValueCarl

Yes, could it be the opportune time for the US government to collect undeserved taxes on the more affluent across its land while macro valuations seem stretched, in advance of the next shoe to drop?

 

If so, 2010 might remain a very bullish, frothy year for stocks and bonds, in order for the central bank's partner, the US Government, to extract its POUND of FLESH from its citizen base.

 

Be careful what you wish for, in addition to being careful "when" and "how" you "value" holdings.

 

Of course, if one believes in perpetual, "Great Inflation," as do Messrs Buffett and Munger, discount everything I say, and carry on, carry on!

 

On the other hand, there's a Crashing Wave Theorist looking at May/June time frames for another horrific correction, possibly even a retest of one year ago. Now, that might be the time to VALUE if one were wanting to pay the tax man!  8) 

 

Before one gets too excited; however, I prefer to think that these masters of disasters who rule our great financial universe, somehow will beat its citizens out of their money first. imo 

 

 

 

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Great topic. I moved my 401(k) into Roth this year. Looking forward to tax-free compounding for next 40 yrs on that...  :)

 

txlaw: 2010 contribution is separate from Rollover. So if you have X in your Traditional IRA or 401(k), then you can still put in $5k in your Roth.

 

Happy compounding...

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txlaw: 2010 contribution is separate from Rollover. So if you have X in your Traditional IRA or 401(k), then you can still put in $5k in your Roth.

 

Kapil, the issue is that my parents are considering converting two of their Traditional IRA accounts to Roths, but their household income disqualifies them from contributing money to their Roth IRAs going forward.  So once they convert, I don't think they will be able to contribute to the accounts. 

 

That actually shouldn't be that big of a deal in their case, but I'm wondering whether they can make a final contribution to their Traditional for 2019 before initiating the conversion process.  Any ideas about that?

 

 

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If the IRA is tied with employer, then rollover is not possible. A standalone IRA can be rolled over into Roth any time with no income limits in 2010.

 

 

 

If you or a relative happen to be 59 1/2 years old, that person can gain control of an employer maintained IRA or a 401K and convert it to an IRA, or this year to a Roth IRA.  I believe this is at the discretion of the employee.  Check with the relevant HR dept or with your accountant or tax attorney to confirm this.  Does anyone on the board know if my understanding about this is correct?

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The $64,000 question is how to convert your IRA to a Roth and not pay taxes. What if one personally owned a company with NOLs. Can the benefit of the NOLs flow thru the business and shelter the income from the conversion???

 

Any other ideas on how to do this??

 

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The $64,000 question is how to convert your IRA to a Roth and not pay taxes. What if one personally owned a company with NOLs. Can the benefit of the NOLs flow thru the business and shelter the income from the conversion???

 

Any other ideas on how to do this??

 

 

 

The value of the IRA upon conversion to a Roth IRA is treated as adjusted gross income.  Therefore, your NOL's should not be able to be used, I think, except as they may be able to be used in the course of your business to reduce your business related income.  I hope my understanding of this is correct.  Valuecfa or others, am I correct?

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It seems to me that conversion makes sense only if the income tax rates in the future for regular IRAs are worse than they are now for Roth conversion. Moreover, there is a non-zero probability that Roth IRA will be taxed in the future in the name of making the "rich" (defined as anybody that can be taxed) pay their fair share. So, whether to convert or not is non-obvious to me. I may take the guaranteed tax deferral of regular IRA and let the chips fall where they may in the future. Besides, if you have future philanthropy in mind, you can always fund those efforts with IRA distributions effectively making the distribution tax-free.

 

If there is a genius on this board who can tell us how to legally do Roth conversion non-taxable, then it would be a slam dunk to convert.

 

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Guest kawikaho

Yeah, I agree.  I've looked at this issue many times when deciding to convert a 401k to an IRA or Roth.  I can either take that hit now or later.  It depends on certain assumptions: assumed CAGR of your portfolio, your current IRA assets, retirement goals, etc...   Let's look at a simple example for someone age 40:

 

case 1) You have an IRA of $200k.  You convert to a ROTH this year and take a hit of nearly 50% on state and federal taxes (assuming my gross income before conversion is below $170k).  You assume growth in that portfolio of about 8% in the next 20 years.  You can draw down the entire account for $440k without any tax penalty.  The total tax hit was roughly $100k.

 

case 2) You have an IRA of 200k.  You keep this and grow your portfolio at 8% a year for 20 years.  The IRA is now $980k.  You have control of your taxes and how you want to draw this down.  At $33k/year with no fixed interest vehicles, you can draw this account down in 31 years at a 25% tax rate.  If you move to a state with no income tax, e.g. Oregon or Florida, you can lower it further at 15%.  Even in this best case scenario, you end up paying 50% more taxes than did in case 1.  

 

case 3) Your assumption about the growth in the portfolio is misguided.  You earn 0% CAGR after 20 years (this CAN and HAS happened--just look at the past 10 years) and you have to draw down both accounts.  In case 1), you've already elected to pay $100k out in taxes.  In case 2), in the normal case you end up paying roughly $50k total as you slowly draw down the account over 10 years.  If you move to Oregon or Florida (or even live in those states part time), your total tax hit is roughly 30k.

 

case 4) If you assume that you're the next Warren Buffet and can grow your assets at 20% CAGR (like several on this board claim), you only take the $100k tax hit like in case 1).  You end up with $3.8 million in assets by age 55.  In case 2), you end up with 7.6 million.  You need to draw down over $250k/year to exhaust this fund by 85 years of age.  That puts you in the 33% tax bracket.  You end up roughly paying $2.51 million in taxes if you lived in Oregon, etc...  Almost 3.4 million if you lived in another state like California.  All in all, you actually did better than taking the tax hit and rolling that amount over in a ROTH.  In the worst case, you end up with 1 million more dollars in net income if you just kept your money in an IRA before the rollover.  

 

There are more cases to look at, but in my case I've determined that in all possible outcomes it was better to stay in a traditional IRA.  That is, the odds pointed to favorable financial outcomes with a IRA vs Roth.  The gov't isn't stupid and nothing comes freely--unless, of course, you guys figure out a way to do the conversion without the tax hit.  That, I believe, is impossible.

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In addition to the many good points raised here, I believe there is another important parameter for those of us who plan on dying "rich": If I am not mistaken, you don't have to withdraw a set amount from a Roth IRA after you turn 70, and can essentially transfer it all free of tax to your heirs.  I view this as a nice optionality, and will probably end up swapping my wife's roth for this purpose (hers has a lot less capital gains than mine since I was more conservative with her account early on)

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case 1) You have an IRA of $200k.  You convert to a ROTH this year and take a hit of nearly 50% on state and federal taxes (assuming my gross income before conversion is below $170k).  You assume growth in that portfolio of about 8% in the next 20 years.  You can draw down the entire account for $440k without any tax penalty.  The total tax hit was roughly $100k.

 

case 2) You have an IRA of 200k.  You keep this and grow your portfolio at 8% a year for 20 years.  The IRA is now $980k.  You have control of your taxes and how you want to draw this down.  At $33k/year with no fixed interest vehicles, you can draw this account down in 31 years at a 25% tax rate.  If you move to a state with no income tax, e.g. Oregon or Florida, you can lower it further at 15%.  Even in this best case scenario, you end up paying 50% more taxes than did in case 1.  

 

 

If you pay $100k from outside the account, then in case #1 the amount you can draw down without any tax penalty is $980k (200k at 8% for 20 years), not $440k.  If one doesn't have $100k lying around, the economics are compelling enough that you should take out a short term loan to pay the tax obligation to maintain the $200k balance in the ROTH.

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Guest kawikaho

Yes, true, but then that assumption holds for the other case as well.  You will have 300k total.  So, in the case of 300k, you have this tax scenario:

 

case 1) 200k in ROTH.  After 20 years at 8% CAGR, $932k with no tax penalties--made a rounding error before so it's not 980k.

 

case 2) 100k in taxable account, 200k in IRA.  After 20 years at 8%, you have 466k in taxable account and 932k in IRA.  You can draw down both accounts however you see fit.  If you liquidate your 466k, you pay the long term capital gain rate (whatever that will be in the future, who knows, let's assume 28%) which is $130.48k.  You can control the liquidation rate of the IRA.  You draw down in the next tax year at the 25% tax rate (state and federal).  You pay over 233k in taxes.  So, total, in the average case, you paid $463k.  That's in future dollars, so we should normalize: that's about $211.3k in today's dollars. 

 

In case 2 you are left with 1.05 million vs. 932k in case 1.  It gets a bit better if you can control your permanent residence to Oregon, Florida, etc...  You can add another 50k to your 1.05 million.

 

So, in this case, it still pays to stay in an IRA.

 

The only reason I see in moving towards a Roth is that you don't think you're going to live a long life and want to hoop it up your last several years.  In that case, a ROTH will come out a little bit ahead without the higher tax rate penalties you will have to pay on a traditional IRA.  That is also assuming you don't liquidate the ROTH before 60.  Then, you pay a hefty tax hit and you're no better off.

 

There are tax estate planning strategies that can control IRA transfers to family members without taking the tax hit, I believe.  However, I'm sure they will close these loopholes in the future.

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Guest kawikaho

 

case 1) You have an IRA of $200k.  You convert to a ROTH this year and take a hit of nearly 50% on state and federal taxes (assuming my gross income before conversion is below $170k).  You assume growth in that portfolio of about 8% in the next 20 years.  You can draw down the entire account for $440k without any tax penalty.  The total tax hit was roughly $100k.

 

case 2) You have an IRA of 200k.  You keep this and grow your portfolio at 8% a year for 20 years.  The IRA is now $980k.  You have control of your taxes and how you want to draw this down.  At $33k/year with no fixed interest vehicles, you can draw this account down in 31 years at a 25% tax rate.  If you move to a state with no income tax, e.g. Oregon or Florida, you can lower it further at 15%.  Even in this best case scenario, you end up paying 50% more taxes than did in case 1.  

 

 

If you pay $100k from outside the account, then in case #1 the amount you can draw down without any tax penalty is $980k (200k at 8% for 20 years), not $440k.   If one doesn't have $100k lying around, the economics are compelling enough that you should take out a short term loan to pay the tax obligation to maintain the $200k balance in the ROTH.

 

I forgot to mention that taking out any loan to pay off the tax obligation would skew the results I've outline below much more in favor of an IRA.  Basically you're taking on leverage, which everyone should know, can be financial suicide.  In the case of an IRA, you could also do something similar and take out a HELOC for 100k at 5% interest and hopefully compound that at 8% for the next 20 years.  Free money without the tax costs.

 

I should also mention after looking at my earlier analysis that I did not normalize the tax hits in the IRA in today's dollars.  That makes the IRA case more compelling.  I did not also show what your account balance would be in either case.  In case 2, even though you paid 50% more in taxes (this is not normalized), you still end up with way more money in the IRA: 699k vs. 466k.  I rushed through that analysis before posting it.  Sorry.  Also, I meant to say Washington, not Oregon, for states with no state income tax.

 

Regardless, if anyone can show me a compelling economic argument for the Roth, I'll bite.  Otherwise, staying in my IRA.

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case 1) You have an IRA of $200k.  You convert to a ROTH this year and take a hit of nearly 50% on state and federal taxes (assuming my gross income before conversion is below $170k).  You assume growth in that portfolio of about 8% in the next 20 years.  You can draw down the entire account for $440k without any tax penalty.  The total tax hit was roughly $100k.

 

case 2) You have an IRA of 200k.  You keep this and grow your portfolio at 8% a year for 20 years.  The IRA is now $980k.  You have control of your taxes and how you want to draw this down.  At $33k/year with no fixed interest vehicles, you can draw this account down in 31 years at a 25% tax rate.  If you move to a state with no income tax, e.g. Oregon or Florida, you can lower it further at 15%.  Even in this best case scenario, you end up paying 50% more taxes than did in case 1.  

 

 

If you pay $100k from outside the account, then in case #1 the amount you can draw down without any tax penalty is $980k (200k at 8% for 20 years), not $440k.   If one doesn't have $100k lying around, the economics are compelling enough that you should take out a short term loan to pay the tax obligation to maintain the $200k balance in the ROTH.

 

I forgot to mention that taking out any loan to pay off the tax obligation would skew the results I've outline below much more in favor of an IRA.  Basically you're taking on leverage, which everyone should know, can be financial suicide.  In the case of an IRA, you could also do something similar and take out a HELOC for 100k at 5% interest and hopefully compound that at 8% for the next 20 years.  Free money without the tax costs.

 

I should also mention after looking at my earlier analysis that I did not normalize the tax hits in the IRA in today's dollars.  That makes the IRA case more compelling.  I did not also show what your account balance would be in either case.  In case 2, even though you paid 50% more in taxes (this is not normalized), you still end up with way more money in the IRA: 699k vs. 466k.  I rushed through that analysis before posting it.  Sorry.  Also, I meant to say Washington, not Oregon, for states with no state income tax.

 

Regardless, if anyone can show me a compelling economic argument for the Roth, I'll bite.  Otherwise, staying in my IRA.

 

 

One reason I converted is that we don't have state income tax (yet) in Washington state, where I live.  Considering that most states have income taxes (and we might move some day) and that Washington state may eventually have a state income tax, it was a good time to lock in the zero-tax forever..

 

Now for the compelling economic argument:

 

Let's say the tax rate is the same today as it would be 30 years from now, and let's say you pay the same percentage today during Roth conversion as you would in 30 years making IRA withdrawals.  Okay, now let's say a conversion today would cost you $200k in tax.  Well, if you choose not to convert and you manage to compound the $200k at the same after-tax rate as the funds in your IRA, then you may find that conversion didn't accomplish anything.

 

So the question is, how are you going to compound that $200k after-tax at the same rate as the money in your IRA?  And if you think you can actually achieve that, then why aren't you employing that strategy in your IRA with your tax-deferred investments?

 

So it's obvious that it's harder to compound the $200k in your taxable account at the same rate as the money in your IRA.

 

That's one of the reason why I converted.  The other reasons are:  1)  no forced withdrawals after 70.5 yrs age  2)  my children can inherit my Roth and leave the money in there compounding tax free.

 

I have a ridiculous sum in there now, and I'm 33 years away from being 70.  I do not want to be "surprised" by a 70% tax rate (same as when I was born) if my account grows to $500m or so by then -- in the IRA, the forced withdrawals would be so large they could easily trip such a tax rate.  35% (today's rate) is cheap by comparison.

 

 

 

 

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case 1) You have an IRA of $200k.  You convert to a ROTH this year and take a hit of nearly 50% on state and federal taxes (assuming my gross income before conversion is below $170k).  You assume growth in that portfolio of about 8% in the next 20 years.  You can draw down the entire account for $440k without any tax penalty.  The total tax hit was roughly $100k.

 

case 2) You have an IRA of 200k.  You keep this and grow your portfolio at 8% a year for 20 years.  The IRA is now $980k.  You have control of your taxes and how you want to draw this down.  At $33k/year with no fixed interest vehicles, you can draw this account down in 31 years at a 25% tax rate.  If you move to a state with no income tax, e.g. Oregon or Florida, you can lower it further at 15%.  Even in this best case scenario, you end up paying 50% more taxes than did in case 1.  

 

 

If you pay $100k from outside the account, then in case #1 the amount you can draw down without any tax penalty is $980k (200k at 8% for 20 years), not $440k.   If one doesn't have $100k lying around, the economics are compelling enough that you should take out a short term loan to pay the tax obligation to maintain the $200k balance in the ROTH.

 

I forgot to mention that taking out any loan to pay off the tax obligation would skew the results I've outline below much more in favor of an IRA.  Basically you're taking on leverage, which everyone should know, can be financial suicide.  In the case of an IRA, you could also do something similar and take out a HELOC for 100k at 5% interest and hopefully compound that at 8% for the next 20 years.  Free money without the tax costs.

 

I should also mention after looking at my earlier analysis that I did not normalize the tax hits in the IRA in today's dollars.  That makes the IRA case more compelling.  I did not also show what your account balance would be in either case.  In case 2, even though you paid 50% more in taxes (this is not normalized), you still end up with way more money in the IRA: 699k vs. 466k.  I rushed through that analysis before posting it.  Sorry.  Also, I meant to say Washington, not Oregon, for states with no state income tax.

 

Regardless, if anyone can show me a compelling economic argument for the Roth, I'll bite.  Otherwise, staying in my IRA.

 

 

One reason I converted is that we don't have state income tax (yet) in Washington state, where I live.  Considering that most states have income taxes (and we might move some day) and that Washington state may eventually have a state income tax, it was a good time to lock in the zero-tax forever..

 

Now for the compelling economic argument:

 

Let's say the tax rate is the same today as it would be 30 years from now, and let's say you pay the same percentage today during Roth conversion as you would in 30 years making IRA withdrawals.  Okay, now let's say a conversion today would cost you $200k in tax.  Well, if you choose not to convert and you manage to compound the $200k at the same after-tax rate as the funds in your IRA, then you may find that conversion didn't accomplish anything.

 

So the question is, how are you going to compound that $200k after-tax at the same rate as the money in your IRA?  And if you think you can actually achieve that, then why aren't you employing that strategy in your IRA with your tax-deferred investments?

 

So it's obvious that it's harder to compound the $200k in your taxable account at the same rate as the money in your IRA.

 

That's one of the reason why I converted.  The other reasons are:  1)  no forced withdrawals after 70.5 yrs age  2)  my children can inherit my Roth and leave the money in there compounding tax free.

 

I have a ridiculous sum in there now, and I'm 33 years away from being 70.  I do not want to be "surprised" by a 70% tax rate (same as when I was born) if my account grows to $500m or so by then -- in the IRA, the forced withdrawals would be so large they could easily trip such a tax rate.  35% (today's rate) is cheap by comparison.

 

 

 

 

 

Eric's argument is more compelling:

 

A):  The younger you are.

 

B):  The higher the rate you think you can compound your money.

 

When estimating a compounding rate, don't sell yourself short if you really know what you're doing and if you know what your sweet spot(s) is/are.  If you're a good investor and have a track record to show it through both the recent bull and bear markets, use that as a basis for estimating a reasonable compounding rate going forward.  If that rate happens to be 15% or 20%,  plug that compounding rate into the two scenarios for the two kinds of IRA's,  and you'll be amazed at the difference over a long period of time.

 

Don' delude yourself into thinking that your tax rate on the hypothetical funds that would be taxed on future investment gains if you didn't use them to pay the taxes for a Roth conversion will be minimal.  That tax rate will probably be   about halfway between the rate on short term gains and the rate on long term gains unless you are able to find a BRK or a FFH early in its history and sit on it for many years.  In summary, the taxation and the inability to be nimble in changing positions when appropriate may cut the per annum after tax compounding rate of the funds that are not tax sheltered by the IRA in half compared to the IRA.

 

Realize that it's more difficult to compound efficiently in a taxable account than in an an IRA of whatever sort because you're always constrained by tax considerations.  Imagine putting 20% of your family's investable funds into a compelling situation and then seeing it pop up three times as high within two months.  How disagreable this would be when it should be a happy occasion.  Should one sell and take a short term gain or wait for a possible long term gain even though it's now way above the estimate of IV?  In an IRA, this type of decision is a no brainer-- take the profit!

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You guys make too much money and live in the wrong states. I live in Texas, am in the 25% tax bracket and only have $20 k in my 401k. This is a no brainer for me.

 

I also may have no taxable income depending on how the job situation works out. The only issue is will I be able to move and roll it over prior to the end of 2010.

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You guys make too much money and live in the wrong states. I live in Texas, am in the 25% tax bracket and only have $20 k in my 401k. This is a no brainer for me.

 

I also may have no taxable income depending on how the job situation works out. The only issue is will I be able to move and roll it over prior to the end of 2010.

 

 

IMHO You should go ahead and make the conversion to a Roth IRA right away without worrying about how you are going to beg, borrow or steal to pay the taxes.  Shhhh.  Don't tell anyone, but there's a free put on the conversion.  At the end of this year, you can undo the conversion if things don't work out so that you have the money to pay the taxes on the conversion.  You can back out of the conversion even during 2011 before your first payment on the conversion to a Roth is due and still have your money in a regular IRA, according to what I've read!

 

 

ERIC, YOU'LL LIKE THIS NEXT IDEA WITH ALL THE OPTIONS YOU BUY :)

 

 

But wait!  It gets even better than an offer on a late night TV  commercial!  If you convert and the value of your new Roth  IRA goes down toward the end of this year, you can also rescind the conversion ( the free put ) and then turn around and convert again to a Roth at a lower basis and lower amount of taxes due that you'll have to pay!  This free put also extends throught 2011, but if I'm not mistaken, you can't jump back in with another reconversion if you exercise your put beyond the end of this year.

 

 

If anyone wants to get cute, instead of being a value investor, he can even convert multiple iRA's into Roth's, put them into volatile, non correlating assets, then undo the  Roth IRA's that go down and reconstitute them at a lower tax basis before the end of the year from what I've read from secondary sources, {I say he rather than he/she because only a guy would even think about doing such a thing! }      ( Better check this one out before you take my word for it and try it ). :)

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I'm in Montana right now home shopping. 

 

The Windermere office in Bozeman has a flyer posted in the window with an AR-15 assult rifle drawn on it.  The large print is "Are you overtaxed?"  If you come to the Republican (militia?) rally, you can enter to win an AR-15 in a raffle.

 

I am still in disbelief -- who knows, perhaps the Republicans will give out enough AR-15 weapons to kill all the liberals and abolish taxes.  33 yrs is a long time for forecasting tax policy.

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One other benefit of conversion:

 

5 years after the conversion, you can withdraw 100% of the conversion amount tax-free (without early withdrawal penalty).

 

So, 5 yrs from now, when I'm 41 I can withdraw the sum of money that I converted to the Roth -- without paying a penalty for withdrawing before age 59.5.

 

The IRA provides no such program -- you pay a 10% early withdrawal penalty in addition to income taxes due on the withdrawal.

 

I don't plan to do that, but it provides the penalty-free option.

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The biggest problem for me is the tax portion you have to pay on the conversion.  If you can multiply your after tax "Roth" 15 times (apx 20% for 15+ years) then the offsetting tax that was paid would also multiply by the same amount.

You can withdraw before 59 1/2 without a penalty if you do equal payments for a period of time. 

Also you have trust congress to not tax the Roth.  The pot (all the Roths) gets bigger each year and as the deficit grows so will the temptation to get into it.  They are already talking about a VAT and in the past they had for awhile, several years ago, they had a penalty tax if you had too much in your profit sharing or pension plan.

Our government says our debt is about 13 trillion when it is actually about 60-70 trillion which is about 194,000 for every citizen.

http://truthin2008.org/content/?articlesource=439

check the above site for "truth in accounting" for the government.  It also has some interesting figures for many of the states.

I used to trust Congress to some extent, until in the 1980's they retroactively changed the real estate rules for deductions and basically put the real estate market into a recession.

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