How can I figure out if IRA to Roth conversion is worth it?

[Mephistopheles]

I'm trying to decide if it's worth converting my parents IRAs to a Roth IRA. I know a big factor here is the expected rate of return on the portfolio. All the online conversion calculators have a max expectation of 12% for us to select, I don't know why. So I was wondering if anyone here has recommendations on how to properly figure this out? Or do I have to consult an accountant?

[racemize]

rate of return should not matter--only the number of tax events matter.  So, you can either get taxed going in (roth), or going out (IRA), the only difference is the tax rate.  Thus, your choice should be made based on the tax rate.

 

However, as Eric has pointed out in another thread, this isn't quite true since you can effectively put more money in a ROTH account (since it is the same number, but one has been taxed already, making it more "effective" money).  That shouldn't apply here.

[Mephistopheles]

rate of return should not matter--only the number of tax events matter. 

 

But what about the opportunity cost of paying taxes upfront vs. paying them well into the future? Let's say hypothetically I make a 20x return over the life of the IRA, and then start paying income taxes at 35% based on minimum distributions vs. paying taxes upfront and not having the opportunity for that money to grow. Wouldn't the former be a better deal?

[tooskinneejs]

I don't think it makes a difference when you pay the tax.  Let's assume $100 of income to be invested, a one year holding period, a 10% annual rate of return, and a 20% tax rate.

 

Pay $20 of tax up front and you invest $80, earn $8 of return, and end up with $88.

Pay tax at the end and you invest $100, earn $10, pay tax of $22, and end up with $88.

 

I think the same applies to a multiple year scenario.  So only the tax rate matters.  Is the upfront rate more or less than the back end rate.  That's the gamble.

[racemize]

I don't think it makes a difference when you pay the tax.  Let's assume $100 of income to be invested, a one year holding period, a 10% annual rate of return, and a 20% tax rate.

 

Pay $20 of tax up front and you invest $80, earn $8 of return, and end up with $88.

Pay tax at the end and you invest $100, earn $10, pay tax of $22, and end up with $88.

 

I think the same applies to a multiple year scenario.  So only the tax rate matters.  Is the upfront rate more or less than the back end rate.  That's the gamble.

 

+1

[matjone]

I don't know your situation, so it depends.  If you don't earn much and your account is small you'll be at a low tax rate when you do the conversion.

 

There's no guarantee that the government is going to keep their promise on anything.  I was thinking about converting mine a while back. I didn't, and I think when Jan 1 rolls around I'm probably going to contribute to a traditional, rather than a roth like I've always done.    The  guarantee is the tax saving now, and I like guaranteed money a lot more than theoretical money on a spreadsheet.

[ERICOPOLY]

You guys are incorrect if you think it's merely whether you pay 25% tax rate now or 25% tax rate later.  It is more nuanced than that.  This is not merely an order of operations thing.

 

The money you pay in tax on conversion settles the tax liability for good.  But then the account compounds at 12% annualized for the next 10 years.  That's (implicitly) tax-free compounding of the tax liability.

 

How are they going to compound their taxable money at 12% annualized for 10 years when 12% is all they can achieve in a tax-deferred account?

 

So therefore, it's not just an order of operations thing.  The most important thing to consider is that there is likely no way they'll be able to achieve the same rate of compounding in their taxable accounts as in their tax-deferred accounts.   Therefore, they should lock in the tax bill as soon as possible.  Otherwise their tax bill will grow at a faster rate than their ability to pay for it.

[matjone]

That's assuming the government doesn't make them pull out part of it like they were proposing

[ERICOPOLY]

That's assuming the government doesn't make them pull out part of it like they were proposing

 

True but at least you lock in the income tax rate before they raise it to 99%.

[Dustin T]

I chose to convert mine in 2009 when the market was crashed. This added to my tax bill that year, but removed my future liability at a discount. I'm not a tax expert, but as I understand things it's advantageous to wait for a pullback vs. doing it while the market is on the high side.

[racemize]

You guys are incorrect if you think it's merely whether you pay 25% tax rate now or 25% tax rate later.  It is more nuanced than that.  This is not merely an order of operations thing.

 

The money you pay in tax on conversion settles the tax liability for good.  But then the account compounds at 12% annualized for the next 10 years.  That's (implicitly) tax-free compounding of the tax liability.

 

How are they going to compound their taxable money at 12% annualized for 10 years when 12% is all they can achieve in a tax-deferred account?

 

So therefore, it's not just an order of operations thing.  The most important thing to consider is that there is likely no way they'll be able to achieve the same rate of compounding in their taxable accounts as in their tax-deferred accounts.   Therefore, they should lock in the tax bill as soon as possible.  Otherwise their tax bill will grow at a faster rate than their ability to pay for it.

 

it depends on whether you have the money to pay for the tax bill I guess--you could just pay the taxes out of the money itself, then the compounding is the same.  If the money they would use for taxes would be invested--fair point.

[bookie71]

But don't forget that the taxes you would have paid will be compounding and growing.  To compare you need to take after tax (1000-250 (tax)) 750 and compare with 1000 compounded. Then you don't normally draw down all at once, so you can somewhat control the tax.  The biggest thing is something you have no control over, Congress and the President.

It is an extremely complex issue and sometimes there is no easy answer.

[ERICOPOLY]

But don't forget that the taxes you would have paid will be compounding and growing. 

 

Not at the same rate they won't -- the tax drag will ensure this.

 

My assumption is that they have the cash to settle the tax bill right now without drawing funds out of the account.  In other words, they have a regular taxable brokerage account where they are investing and paying taxes on those investments.

 

It would be easier if the OP would gives us more information.  Maybe they don't have the cash to settle the tax bill without drawing down the retirement account in the process.

 

Plus if they really do have tons and tons of cash in their taxable account, then go ahead and pay the tax bill and convert today.  Then, put some of that extra taxable cash into low-cost variable annuity.  Then when they withdraw the gains from the variable annuity, those withdrawals can be dribbled out to tax advantage of the low tax brackets.

 

Basically, he needs to divulge more information about how flush his parents are.

 

I had (and still have) a lot of money in my taxable account.  So I can invest that in variable annuities where they grow just like an IRA,tax-deferred, and have similar withdrawal rules as IRAs.  It's that money that I can dribble out piece by piece every year at low tax rates.

 

So the Roth conversion was an easy decision for me, especially so because I was flush in the taxable funds department.

 

However, I haven't invested in variable annuities yet -- it was something I was considering at the time.  I was only 35 or so years old when I did the conversion.  So I figured maybe some day down the road I would be working again and building up another pre-tax IRA.  Plus, I was able to move to California last year because I had that big tax bite already out of the way while I was still in Washington state where they have no income tax.

 

 

[Guest longinvestor]

I chose to convert mine in 2009 when the market was crashed. This added to my tax bill that year, but removed my future liability at a discount. I'm not a tax expert, but as I understand things it's advantageous to wait for a pullback vs. doing it while the market is on the high side.

That's assuming the government doesn't make them pull out part of it like they were proposing

 

True but at least you lock in the income tax rate before they raise it to 99%.

 

Agree and I also converted just enough so that I could foot the conversion tax bill. The tax bite stung a bit, but I took the two year tax payment allowed in 2010-11. The timing worked out perfectly, the account is up 50% since, essentially Mr. Market paid back the entire tax bite and some.

 

I would summarize my experience (in hindsight) as below:

1) If you are postponing some important consumption now to achieve tax free compounding, it may not be worth it. Especially since the Roth is the last bucket you should be dipping into in later life. Lot of unknowns. Hate the thought that someone else (caregivers, healthcare, who knows who etc) may end up consuming much of it.

2) If you have enough other assets that will cover / exceed your needs for the duration of the tax free compounding of the Roth, give good thought to your estate planning and future charitable giving as the Roth will play large here. I'm no tax expert but charitable giving from the Roth account??

3) Something fairly certain about tax rates, estate taxes etc. I don't think they are going to be less in the future. Like Ericopoly says, locking in the tax rate made a lot of sense to me.

4) I wish I had converted to Roth a long time ago. Time they say is the friend of compounding but is Roth's bosom pal. Longer the better, I surely will be telling anyone I know who is in their 20's.

 

 

[ERICOPOLY]

give good thought to your estate planning and future charitable giving as the Roth will play large here. I'm no tax expert but charitable giving from the Roth account??

 

The upside to that is the government is redistributing your tax money away to others.  So my line could be "I already gave at the Treasury".  I mean, churches used to handle much of charity before the age of big government.  That was Romney's argument about how he gave 10% of his income to the Mormon church and they handle the charitable distribution of it.  Well, if that argument flies then my line could be that I paid my taxes and they handle the charitable distribution of it.  I know, it's weak, but when you are in 52% tax bracket in California it actually has some merit to it.

[Guest longinvestor]

give good thought to your estate planning and future charitable giving as the Roth will play large here. I'm no tax expert but charitable giving from the Roth account??

 

The ... I mean, churches used to handle much of charity before the age of big government.  That was Romney's argument about how he gave 10% of his income to the Mormon church and they handle the charitable distribution of it.  ...

 

I would like to script my own charity, not pre-determined by an old book (church) or a newer one (government).

[bookie71]

You are probably correct in that there will be no taxes on the Roth in the future, but talk  to some folks who invested in real estate and then found in the 80's that congress changed the rules and they couldn't deduct their losses.

Also if they put in a VAT then you could be indirectly taxed.

[ERICOPOLY]

You are probably correct in that there will be no taxes on the Roth in the future, but talk  to some folks who invested in real estate and then found in the 80's that congress changed the rules and they couldn't deduct their losses.

Also if they put in a VAT then you could be indirectly taxed.

 

That's true about "some" folks with regard to real estate.  However others never experienced that.  For example, I invested in rental housing in the early 2000s and I deducted all of my passive real estate losses against my Microsoft income, without limits to the amount, for a couple of years before I sold my properties. 

 

The trick is that either you or your wife needs to earn the designation of "Real Estate Professional".  The funny thing is, the rental were mine, but I got the write-off anyways given that I was married to a "Real Estate Professional".  Here is a recent article about the technique:  http://www.inman.com/2012/09/14/real-estate-pros-can-deduct-rental-losses/

 

[ERICOPOLY]

Thus, if you are a guy with a lot of real estate investments but unable to use them, ask your wife to get a realtor's license.  Or if you're single and have a guy friend who is a realtor, marry him.  Maybe you're just buddies, so what... you can both still go out on dates with girls...  if somebody from the IRS calls it a sham just tell them you're into "open marriage"  :D

 

[Mephistopheles]

Wow, thanks for all the replies so far everyone! This is pretty confusing.

 

But don't forget that the taxes you would have paid will be compounding and growing. 

 

It would be easier if the OP would gives us more information.  Maybe they don't have the cash to settle the tax bill without drawing down the retirement account in the process.

 

 

 

Yes they have the cash to pay the tax bill without tapping the IRA. Furthermore they are in the 28% bracket right now but am not sure what bracket they will be in retirement. It depends on how much the IRA (if kept traditional) grows I guess, and how much they have to withdraw every year.

[ERICOPOLY]

Wow, thanks for all the replies so far everyone! This is pretty confusing.

 

But don't forget that the taxes you would have paid will be compounding and growing. 

 

It would be easier if the OP would gives us more information.  Maybe they don't have the cash to settle the tax bill without drawing down the retirement account in the process.

 

 

 

Yes they have the cash to pay the tax bill without tapping the IRA. Furthermore they are in the 28% bracket right now but am not sure what bracket they will be in retirement. It depends on how much the IRA (if kept traditional) grows I guess, and how much they have to withdraw every year.

 

 

Then they might have enough money to settle the tax bill as well as extra money to invest on top of that?

 

Here is an idea -- the Vanguard variable annuity:

https://personal.vanguard.com/us/funds/annuities

 

The variable annuity is basically a mutual fund product that compounds tax deferred -- you get taxed on the gains as income when you withdraw them in retirement.  Sound a bit like an IRA?  Well... there are no contribution limits, unlike an IRA.

 

Some people feel like a full RothIRA conversion puts them in the position of giving up the ability to dribble out income at low tax rates during retirement...  don't be that way!  If you can afford to do this, you can establish one of these variable annuities that also compound tax deferred -- and those earnings are what you'll withdraw at low tax rates  :D

[watsa_is_a_randian_hero]

Ericopoly - do you know of any companies that will set up the variable annuity structure but allow for investments in individual stocks?  It would be much more appealing if I didn't have to invest in a mutual fund.

[Guest longinvestor]

Ericopoly - do you know of any companies that will set up the variable annuity structure but allow for investments in individual stocks?  It would be much more appealing if I didn't have to invest in a mutual fund.

 

+1; Would like to know myself. My guess is not since the FI offering these are attached to the teats of fees from the annuities.

 

http://www.fool.com/retirement/annuities/annuities02.htm

 

has an illustrative example on the effect of fees.

 

I have a distaste for paying fees for no guarantee in performance.

 

 

[ERICOPOLY]

Ericopoly - do you know of any companies that will set up the variable annuity structure but allow for investments in individual stocks?  It would be much more appealing if I didn't have to invest in a mutual fund.

 

I looked a while back and couldn't find any that allowed you to manage the investments yourself -- you get stuck choosing from mutual funds or bond funds.

 

The variable annuities are famous for being expensive in terms of fees, which is why I was careful to point directly to Vanguard's site.  They are very inexpensive relative to most.  It's about 50 basis points in total all-in fees for their bond or REIT funds wrapped in variable annuity.  That's relatively high for a vanguard fund, but they know they have you over a barrel because your alternative is perhaps paying very high marginal tax rates annually.  However with these very low interest rates the expense becomes a high percentage of the actual gains -- it's a bit silly.

 

But I think if you were going to go that route, it would be better to do it with income funds that generate investment income that is normally taxed at the high personal income rate -- one that is high because you perhaps are also working at the same time.  Then later when you retire your tax rate will be lower.  So you use it as a tool to lower your effective tax rate, and of course you get the valuable deferral of the taxes.  Especially useful if you are working at a career in California but plan to retire in a state with no income tax -- although in that case the RothIRA conversion doesn't make as much sense.

 

But since we're talking about somebody else's parents, I figured the words "mutual funds" or "bond funds" are likely what they want anyhow.  So the investment restrictions of variable annuities aren't that bad for them.

[locatevalue]

You are probably correct in that there will be no taxes on the Roth in the future, but talk  to some folks who invested in real estate and then found in the 80's that congress changed the rules and they couldn't deduct their losses.

Also if they put in a VAT then you could be indirectly taxed.

 

That's true about "some" folks with regard to real estate.  However others never experienced that.  For example, I invested in rental housing in the early 2000s and I deducted all of my passive real estate losses against my Microsoft income, without limits to the amount, for a couple of years before I sold my properties. 

 

The trick is that either you or your wife needs to earn the designation of "Real Estate Professional".  The funny thing is, the rental were mine, but I got the write-off anyways given that I was married to a "Real Estate Professional".  Here is a recent article about the technique:  http://www.inman.com/2012/09/14/real-estate-pros-can-deduct-rental-losses/

 

 

Thanks Eric, I didn't know this till now. I am certified realtor but my number of hours as relator is not that much as i have  a full time job. I recently found bargain rental property in my neighbourhood and bought it, will close it this week. I will see if i can use this special clause. When you say loss,Are you talking after depreciation ? if i can't count depreciation then i will be making a profit as it will generate +ve cash flow on this property.