The Year of the Roth

[Guest kawikaho]

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.

 

I don't see that as a benefit.  You still have to pay the tax obligation from a taxable account.  So, where's the benefit?

[Guest kawikaho]

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.

 

Exactly.  I mean, if you're gonna start talking about 70% taxes and blah blah, you might as well also consider taxation on a ROTH account.  All equal and possible outcomes.  All of the outcomes I've looked at leads to more favorable outcomes with the IRA.  I don't expect to have hundreds of millions in a non-taxable account.  I expect to draw down the IRA before 60 and have it depleted by the time I die.

[gaf63]

For me the ability to take withdrawals when I want from a Roth and not on a schedule starting at age 70.5 as in reg. IRA is an important consideration. I dont want to be invested in equities  and have to sell at inopportune times to meet the ira schedule.  Also odds of taxes going up are pretty good, and if one has other income with the proceeds of the IRA added , the tax levels will be  higher than you suggest(Im in Calif).  So I'll pay for the privilege in taxes which I may or may not recover, but I'll be able to withdraw  in 10 or 15 yrs at my discretion.  So at my age I am debating whether the tax cost is worth the above benefit.  Money would be invested in FFH which if it compounds at 15% ,  .......  big if , Gaf

[bookie71]

Just try to keep a couple of years RMD in cash, it usually doesn't take longer to recover or top out.

[ERICOPOLY]

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.

 

Here is the mistake you are making -- you are stating a truth (tax rates the same) but it is leading you to an incorrect conclusion.

 

I'm currently studying for the GRE, and the Princeton Review recommends "plugging in the numbers" to ace the algebra portion.  So let's take their advice here and plug in some numbers.

 

Suppose you are faced with the proposition of converting a $100k IRA today to a Roth IRA and paying $35,000 in tax (35%), or withdrawing it from your IRA in 30 yrs and paying the same rate -- 35%.

 

Okay, so you choose not to convert.  Then put the same $35,000 into your brokerage account and invest this as your "tax reserve" that you intend to use to cover the taxes on your IRA withdrawals 30 yrs down the road.

 

Now, suppose your IRA compounds by 10% per annum.  In 30 yrs time it is worth $1,744,940.  So you choose to withdraw it at that time and you owe tax of $610,729.

 

Now, let's say that you invest your "Tax Reserve" in the exact same investments as you held in your IRA, but due to drag from annual taxes due, you only achieved 8.5% per annum.  Your tax reserve is now worth $404,538.

 

$404,538 is NOT equal to the tax you owe of $610,729.

 

Sorry, but you should have done the conversion.  You just gifted the government $206,191.

 

You are paying 50% more in taxes for your gamble. 

 

Your gamble is that you can compound your annually taxed "reserve" at the same rate as your IRA compounds tax-deferred -- good luck, you'll need it.

[ERICOPOLY]

In short... paying the tax today (Roth conversion) is logically equivalent to putting your tax liability in a tax-exempt investment account.

 

Refusing to pay the tax today (no conversion) is logically equivalent to saying "I think it's better to put the tax liability in a taxable account rather than a non-taxable account".  I hope people don't make that choice now after seeing the math.

 

(this assuming the tax rate upon conversion is the same as that upon IRA distribution)

 

 

[ERICOPOLY]

You should note also that my compounding numbers were modest -- 10% in the IRA and 8.5% in the tax reserve.

 

Let's double them and make them 20% in the IRA and 17% in the tax reserve.

 

Now you have a tax liability of $8,308,170 but your tax reserve has only grown to $3,887,262.

 

So your tax is now 113.7% higher than it would be if you'd just do the Roth conversion today.

 

Today, you are looking at that 35% tax and shrugging, saying... oh well, it will still be 35% in 30 years so I'd just as rather pay it then (I think that's Kawihako's thesis).  But in reality, under these new numbers I will be paying 35% and he will be paying the equivalent of 74.8%.

 

And here he was saying that 70% was unrealistic!!!

 

[Munger_Disciple]

Ericopoly,

 

I believe that your math on tax reserve for regular IRA is wrong for the following reason. The tax reserve is inside the regular IRA, not outside in a taxable account. Therefore it compounds tax free until withdrawals are made.

[Rabbitisrich]

Ericopoly,

 

I believe that your math on tax reserve for regular IRA is wrong for the following reason. The tax reserve is inside the regular IRA, not outside in a taxable account. Therefore it compounds tax free until withdrawals are made.

 

Ericopoly assumes that the worker starts with enough cash outside of his/her IRA to cover the tax, so the IRA and the ROTH IRA compound at the same dollar amounts until the retirement period. That assumption may have to be relaxed given the current state of the economy, and its impact on older workers without a college degree.

 

Another point that individuals should take into account is the effect of multiple period tax deductions for qualifying IRA contributions. For individuals who anticipate major differences in their active-retired tax brackets, those contributions may increase the attractiveness of an IRA.

[ERICOPOLY]

Paying the tax today with cash in a taxable account is in effect implicitly a roth-like contribution. That's why it's so beautiful! There is no other special deal for making such a large one-time contribution.

[ERICOPOLY]

To make the proposal simpler perhaps we can change the wording of the "roth conversion" to "one-time opportunity to make a Roth contribution as large as your tax liability".  Pretend that tax rates would be the same.  Would you argue that there is no benefit to a large Roth contribution?

[Munger_Disciple]

In effect the scenario Ericopoly is considering is not Roth conversion, but an additional contribution equal to the tax due. If that is the case, for correct comparison, one should consider the case of potentially making an equivalent contribution to a regular IRA if possible. Then the two cases are equivalent. If such a regular IRA contribution is not possible (due to limitation on the size), Roth is potentially better if tax laws do not change in the future to make Roth withdrawals taxable.

 

[ERICOPOLY]

In effect the scenario Ericopoly is considering is not Roth conversion, but an additional contribution equal to the tax due. If that is the case, for correct comparison, one should consider the case of potentially making an equivalent contribution to a regular IRA if possible. Then the two cases are equivalent. If such a regular IRA contribution is not possible (due to limitation on the size), Roth is potentially better if tax laws do not change in the future to make Roth withdrawals taxable.

 

 

Look, if you are not already maxing out your IRA contribution opportunities then perhaps you have reasons for doing so (low on money perhaps).

 

Me, I would do both.  I would max out my IRA contribution (if I could make one at all!) and I would ALSO do the Roth conversion to establish the stealth Roth-like tax reserve.

 

This is not mutually exclusive, unless you can't afford to do both.  I never can have too much of a good thing when it comes to tax shelters.

 

Taking money out of your IRA (as was suggested previously) to pay the conversion tax is stupid if you have a large taxable account which can easily handle the conversion expenses -- the goal is to maximize tax-deferred compounding, rather than taking money out early to pay off a future tax liability in a shell game that gets you nowhere.

 

I'm not allowed to make regular IRA contributions -- I don't have any earned income.  So this conversion opportunity is a bonus -- the only way I can increase my tax-deferred compounding via contributions.

 

 

[Guest kawikaho]

Just to clarify:

 

"Can I have both a traditional and a Roth IRA?

 

There’s nothing wrong with having both. In fact, it gives you the chance to benefit from both front-end and back-end tax savings. But remember that you can only contribute up to $5,000 per year to any combination of traditional and Roth IRAs that you have. You can’t contribute $5,000 to each. On the other hand, your annual $2,000 contributions to an Education IRA are entirely separate from the $5,000 annual contribution limit for traditional and Roth IRAs."

 

If you can afford to pay out the ROTH conversion tax obligation from a taxable account, that's the way to go.  If not, don't do the conversion. 

[Munger_Disciple]

If you can afford to pay out the ROTH conversion tax obligation from a taxable account, that's the way to go.  If not, don't do the conversion.

 

I agree with this and thanks to everyone for the excellent discussion on Roth & regular IRAs. It certainly clarified my own thinking on this matter.

[kapilm]

Very informative discussion. Great input, everyone !

[twacowfca]

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.

 

 

Watch your backside Eric!  April 1 was opening day of hunting season for liberals.  Dick Cheney is rumored to be on the way to Montana,  and this time he's not using birdshot!

 

:)

 

Seriously, I like the idea of having well regulated militias the way Singapore and the Swiss do it, but I generally despise the idea of unregulated vigilanties or militias.  I imagine that because of who I am, I would be the one who would wind up being at the wrong end of the rope!  The only thing worse IMO is when all power is in the hands of a central government's executive.  Then, everyone else lives or dies at the pleasure of the king or the "beloved leader" or whoever.

 

Bozeman has an interesting history.  It sprang up after the civil war as a gold rush town, full of hard drinking miners and other misfits.  Among the misfits were many outlaws and gangs that murdered miners for their gold. The outlaws so intimidated the town that no jury would bring a unanimous verdict against a killer for fear of their own lives.  

 

The better citizens of Bozeman then followed the democratic tradition and formed a Committee of Vigilance.  The secret committee picked off the outlaw gangs one by one and did what vigilantes generally did back then.  HANG EM HIGH!

 

If you want to learn more about their history, pick up a copy of The Bozeman Trail while you're there. Or rent a copy of the classic Jimmy Stewart western,  The Man Who Shot Liberty Valance,  based on the book by the same author.  

 

Interestingly,  Charlie Munger's great grandfather was a judge who attempted to help bring law and order to that wild territory.

[bookie71]

The problem with vigilanties is that the solution soon becomes the problem.

[Guest kawikaho]

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.

 

Here is the mistake you are making -- you are stating a truth (tax rates the same) but it is leading you to an incorrect conclusion.

 

I'm currently studying for the GRE, and the Princeton Review recommends "plugging in the numbers" to ace the algebra portion.  So let's take their advice here and plug in some numbers.

 

Suppose you are faced with the proposition of converting a $100k IRA today to a Roth IRA and paying $35,000 in tax (35%), or withdrawing it from your IRA in 30 yrs and paying the same rate -- 35%.

 

Okay, so you choose not to convert.  Then put the same $35,000 into your brokerage account and invest this as your "tax reserve" that you intend to use to cover the taxes on your IRA withdrawals 30 yrs down the road.

 

Now, suppose your IRA compounds by 10% per annum.  In 30 yrs time it is worth $1,744,940.  So you choose to withdraw it at that time and you owe tax of $610,729.

 

Now, let's say that you invest your "Tax Reserve" in the exact same investments as you held in your IRA, but due to drag from annual taxes due, you only achieved 8.5% per annum.  Your tax reserve is now worth $404,538.

 

$404,538 is NOT equal to the tax you owe of $610,729.

 

Sorry, but you should have done the conversion.  You just gifted the government $206,191.

 

You are paying 50% more in taxes for your gamble. 

 

Your gamble is that you can compound your annually taxed "reserve" at the same rate as your IRA compounds tax-deferred -- good luck, you'll need it.

 

By the way, you also need to claim state taxes on that 100k conversion.  So, whatever your AGI is that year plus the 100k should put you into the top tier for most places.  In California, add another 10%.

[ERICOPOLY]

I don't have state tax thank goodness. One day I might live in such a state -- all the better reason to convert now for my situation. I think many wealthy Californians just have second homes elsewhere to avoid it.  Just get a place in Jackson Hole -- it will pay for itself in tax savings if you have enough taxable income.

[Munger_Disciple]

I currently live in CA (the state tax is ridiculously high), and thinking along the lines of Ericoploy's post, I hope to establish residency via a second home in a zero tax state in the future.

[UhuruPeak]

I currently live in CA (the state tax is ridiculously high), and thinking along the lines of Ericoploy's post, I hope to establish residency via a second home in a zero tax state in the future.

 

You will still need to spend >183 days/year in that other state...

[Munger_Disciple]

I understand; that is my plan. I guess Florida, Nevada, Texas, Washington, NH are the options.

[Myth465]

A lot of Californians are moving to Austin. It feels like the piece of Cali that broke off and got lost in Texas.Thanks for all the info Eric.

[twacowfca]

I currently live in CA (the state tax is ridiculously high), and thinking along the lines of Ericoploy's post, I hope to establish residency via a second home in a zero tax state in the future.

 

You will still need to spend >183 days/year in that other state...

 

 

And, if CA is like my state, you'll have to establish bona fide residency in the new state before tax day, April 15, 2010.