Why the Roth Conversation Is A Bad Deal For You

The following is a guest post by Neal Frankle from Wealth Pilgrim.  
 
Some very smart people advocate converting your IRA to a ROTH right now but I can’t understand why.

To be sure, if you convert your traditional IRA into a ROTH, your distributions from the ROTH will be tax free (assuming you had the money in the account for at least 5 years and you are over 59 ½) and you don’t even have to take distributions if you don’t want to.

With a Deductible IRA, you must pay taxes when you make withdrawals and the withdrawals are mandatory.

That’s all in the ROTH’s favor of course.

On top of that, account values are very low right now.  So even though you’d pay taxes if you convert to a ROTH, the taxes are lower because of the depressed values.

Sounds like a no-brainer in favor of converting….right?  Wrong.  It’s far from a no-brainer…..its very much a “brainer” in fact.

Let me explain by way of example. Assume the following:

1. You are in the 30% tax bracket (both before and after you retire).
2. You have $100,000.
3. You will generate retirement income from your account starting in 20 years.
4. You will earn 8% on your account until you retire.
5. You will earn and withdraw 5% of the value of your account starting in 20 years.

	Traditional	ROTH IRA
	IRA	Conversation
Initial IRA Investment	$100,000	$70,000
Rate of Return	8%	8%
Value in 20 Years	$466,000	$326,000
Withdrawal Rate	0.05	0.05
Gross Income	$23,300	$16,300
Percentage to You After Tax	70%	100%
Net to You	$16,310	$16,300

The first column illustrates what happens if you don’t convert your IRA.  We assume that this person’s total net worth is $100,000 and it’s all in his IRA. He invests his $100,000 at 8% for 20 years.  It grows to $466k which generates $23,300 in annual income on which he pay taxes and is left with $16,300 in annual income.

The second column illustrates the poor sap who converts to a ROTH.  This person starts out with $100,000.  He had $70,000 in an IRA and $30,000 in a checking account.  He converted the $70,000 to a ROTH and needed to write the Treasury a check for $30,000 to pay the tax. (Had he paid the tax from the Traditional IRA, the comparison would even be more lopsided against conversion).  So his ROTH is $70,000 and his checking account is empty.  He also grows the money at 8%.  After 20 years the account grows to only $326k and that only earns $16,300 but he takes that money and pays no tax on it.

As you can see, the income amounts are just about the same.  So why do I say that the Conversation is a bad deal?  Two reasons:

1. If you keep your traditional IRA, you get the tax break now.  If you go with the bird in the bush (otherwise known as the Roth IRA) all you get is hope that you’ll get a tax break at some point in the future -- maybe 20 or 30 years from now. You get to spend the next 20 years praying that Congress doesn’t change its mind.  Well…..after all….they’ve never changed the rules before….right?

2. Even though you MUST pay taxes on the ROTH conversion, you may actually never pay taxes on the Traditional IRA. Think about it.  What if you never withdraw the money? Even though you do have a required minimum distribution amount, you may actually outlive the IRA.  It happens all the time.  And if it does, you can pass the IRA to your beneficiaries and stretch out that tax deferral for decades to come.

The only time you might want to choose to convert is if:

a. You are in a low tax bracket now.
b. You speculate that your tax bracket will be much higher when you retire.

Instead of making this decision based on how much tax you’ll end up paying, make the decision based on which will create the most income for you over your lifetime -- net of taxes of course.

The example above shows that the net cash flow to you will be about the same regardless of the decision you make. That being the case, why take the chance that Congress will change its mind?  It just doesn’t pay.

Comments

[rwh]

What the example also illustrates is a tax that is deferred over a long period of time is essentially a tax avoided.

I have often read or heard people complain that because their money is "tied up" in a capital investment they should get extra compensation because of it. This argument is often used to justify doing away with the capital gains tax. But as you can see, if you hold an investment for decades while deferring the tax, you end up in a position very similar to where you would be if the investment was tax free to begin with.

[Eugene Krabs]

Yes, I do agree with this. In fact, elsewhere, I've argued to basically sit down and crunch the numbers and see what will work best for you.

However, and I admit this is speculative, but our current administration and the past one have massive spending programs in place. That money has to be paid back sooner or later, and it may come out in the form of higher taxes later on.

Therefore, IF it makes sense to convert them, you might as well convert them now. I'm also not suggesting that we should convert our IRA entire account overnight either. For example, I'm planning to do it a little bit at a time, depending on how much room I have to work with within my tax bracket.

It's kind of funny that I should say this because I used to believe in not speculating future tax policies. But the national debt is real, and if we are hoping to survive as a nation, something has to eventually give. In other words, I'd rather work with what I do know right now than take my chances at a gloomy prospect of what may be to come.

Again, this is coming from a guy who has debated that one should NOT be fixated on the Roth, but rather, need to be able to weight the pros and cons of Roth vs. Traditional, and do what works best for you. I still believe in that, but all things being equal, if the numbers make sense to do the conversion, I say go ahead and do it now.

[savvy]

The calculations are flawed because you're not comparing 'apples to apples'. A better comparision would be scenario A - $100K IRA and $30K in cash - vs scenario B - $100K converted to Roth IRA and the $30K in cash went to taxes. Now there's the same amount in the IRAs, just less available cash on hand.

The traditional IRA will net $16,130 and the Roth IRA will net $23,300. Your loss is the opportunity cost of that $30K you no longer had to invest, which is $4895. $16,130 plus $4895 is $21,025 which is still less than what the Roth nets you. Therefore the Roth conversion is the better choice.

[Bill]

Thanks for comfirming my thinking about Roth IRA conversion versus a traditional IRA.

Please note that you are using the word conversation instead of conversion in your article.

[MonkeyMonk]

I agree with Savvy. The whole basis of the calculation seems flawed to me. He's essentially comparing a $100,000 traditional IRA to only a $70,000 Roth IRA.

[acehbee]

I agree with Savvy above. The calculation is very flaw. I did the conversion earlier this year (not IRA to Roth IRA, but 401k rollover to Roth IRA) and I think it is a better option.

If you have $100,000 in traditional IRA, when convert to Roth, you still have $100,000 in Roth IRA. The thing is you have to come up with cash for tax. The whole arguments on this article is very weak, and personally I was surprised that FMF let this article pass and post it on the web.

Let's see two reasons he posted here:
1. Speculative. I can't say what the government will do. But in the case they change the rule on Roth, my guess is that they will tax the gain, not the principal money that have been tax.
2. If I die, won't I be able to pass the Roth to my beneficiary and possibly continue to grow tax deferred too until it is withdrawn?

Either, the comparison of 'apple to orange' in this case is flaw. I checked Savvy's numbers, it seems right. May be FMF should post another article to clarify some number.

[Apex]

Wow, where to start. This post has some issues with inaccuracies, and bad math.

It may or may not be the correct choice to convert from an IRA to a Roth. But nothing in this post will help you make the correct decision and may lead you to the wrong one.

First Savvy is completely correct. The power of the conversion is you get to convert all 100K to a Roth and its all in there and all grows to the same number as the traditional but its all tax free. Why does the author assume the first person has 100K in an IRA and the second only 70K. Thats rediculous, it's the same person. I have actually never seen the comparision done this way and it's just mathematically wrong. Obviously you have to have the cash on the side to pay the taxes but I have converted IRAs to Roth's and that's exactly what I did. And in this scenario that extra cash on the side that the IRA person gets to keep earns income that is taxed every year and thats why they fall behind. The Roth holder has now sheltered all of the 100k from taxes for the rest of their life and potentially the rest of their heirs life as we will see below.

Second as Krabs mentions, everyone always assumes tax brackets are going to stay the same. Anyone who has taken even a cursory review of our entitlement mess coupled with current debt and deficit problems and the idea of the govt taking over health care in some form which they will probably eventually succeed at doing, knows taxes must go way way way way higher in the future. Can I put enough ways in there? It has to be massively higher. Either that or slash social security and medicare and medicaid and don't take on any extra health care issues and pay down the deficit, etc. Anyone think that is going to happen? Lets see, under the Republican administration who is supposed to want smaller govt we added to medicare with part D which is currently running 60 billion dollars more in payments than the extra premiums bring in. Yes, govt cutting these programs seems like a good possibility doesn't it? Because of this I have heard many people begin to argue the traditional IRAs and 401ks are a bad idea. Pay the tax now when its cheaper. I don't entirely disagree with that. I am maxing my 401k though and I plan to strongly consider doing massive conversions to Roth's in the future before rates start to really climb to protect the money from massive tax increases which I believe are likely, not in the very near term but eventually. If you want to see where we are likely going, just look to Europe and Canada, we are probably a generation or two behind them and I don't really want to pay their tax rates.

Thirdly, the idea of not ever paying the tax on an IRA is silly. Does it really matter if "YOU" pay the taxes. The whole point of it is either you need the money and thus you will pay the taxes or you don't and then your heirs will. If you leave it to your heirs to deal with you will have left them a better deal if you converted to a Roth. Here's why. When you die your heirs will get that IRA and likely be in the prime money earning years of their life and thus in very high tax brackets (and probably even higher than now due to almost certain increase in tax rates by then). The tax laws require them to start making minimum withdrawals the minute they inherit it. With a Roth, they can inherit it and either start minimum withdrawals or wait for up to 5 years after the death of the owner to start withdrawals and then the withdrawals are again all tax free so the beneficiaries tax bracket at the time is irrelevant. With an IRA you will pay the tax or your heirs will pay it for you at likely an even higher rate.

The author makes the point about the government changing the rules. And anything is of course possible. Why he never considers them changing the tax brackets I don't know .... But if the government does change the rules on the Roth IRA it would be nearly impossible for them to tax that which has already had tax paid on it. If they did this they would effectively need to tax non-deductible contributes to normal IRAs too. So that leaves them with a few other options, taxing the earnings, taxing the earnings going forward from the point of the law, or simply eliminating the Roth so that no one can contribute any new money to them. I would argue the last one is the most likely thing they would do because because the backlash from the literally 10s of millions of people who have Roth IRAs and now Roth 401k's through work is not likely to go well for them (just like the little hoopla about the govt taking over our 401ks that hit the press this fall was rediculous, if they tried that I guarantee you a mob of pitchforks ....) So this is even more reason to get as much money into a Roth now as possible. They may eventually take this vehicle away and if they do it will be too late.

I concede that anything is possible and they could decide to completely change the law and tax money already in a Roth that has already paid the tax up front or on the earnings that were supposed to be tax free. I will just say that the day they even seriously debate that is the day that I withdraw all my money from my Roth and move it to another country and they can say good bye to it for ever and I am certain millions of others would do the same. People who have decent money didn't get it by being stupid and they are not going to let the government steal it back. There is just no plausible way for them to pull off re-taxing the Roth and get away with it, in my opinion.

Each person needs to review their own situation, and it's a good idea to have some money in both vehicles. Generally people have a hard time understanding all the complexities around converting to a Roth versus keeping a traditional IRA and it makes sense because the issues are tricky. If you don't get those right you can't make the right decision.

[Neal Frankle]

Thanks. I respectfully disagree with the people who think the math is off.

The math is correct for the scenario I used.

Savvy's new example would assume a $130k IRA converted into a $100k IRA vs a $100k traditional IRA. But that really isn't right. If you have $100k converted into a ROTH, you'd have to start with $142,000 (in 30% bracket). So if you compare a $100k ROTH to $100k Traditional PLUS $42,000, THAT would be accurate. In 20 years, $42k grows (in tax deferred annuity) to $195k which will generate $6825 after tax. Total income for traditional IRA is $6825 + $16310= $23135 which means its about $150/year more attractive to convert.

Its not worth the risk of the government changing its mind for that chump chane. Also, its not a good choice to give up the benefits of the stretch IRA (not discussed here) for $150/year.

[Plex]

Not going to check whether the math is bad or not, but I really had to stop reading after a saw a huge assumption (and strange) assumption being made right from the start.

The person has the exact same taxable rate before and after retirement. This is a very uncommon scenario. People usually do not spend far more when they are retired than they did when they were working (which is what this assumes).

The big trade off between Roth and non-roth individual accounts are the difference in tax brackets between working and non-working. Ignoring this from the start and making any sort of calculations is going to make the results way to inaccurate.

[Kathy F]

What about the dividends/interest that the Roth earns in the years during retirement? That does not get taxed, whereas it would in the traditional IRA but I don't see that in the analysis. I thought that was one of the advantages of the Roth.

[Apex]

I also just have to point out the sloppy math of the author. I thought it was odd that the IRA resulted in 10 dollars higher withdrawals per year because it should have come out the same. Well it does. He rounded the numbers of the returns which are actually: 466,095.71 & 326,267.00

As you can see this results in a 3 times larger rounding error for the Roth and when you do the math on this you get exactly the same 16,313.35 withdrawal from each per year.

its minor but he does refer to this difference when he says "As you can see, the income amounts are just about the same." If you are observing you might conclude that the IRA is slightly better due to the 10 dollars. But it's not.

Actually they are exactly the same in his example (which is incorrect to begin with). This is unfortunatley another example of the sloppy approach given to the topic in this article.

[Apex]

"Savvy's new example would assume a $130k IRA converted into a $100k IRA vs a $100k traditional IRA. But that really isn't right. If you have $100k converted into a ROTH, you'd have to start with $142,000 (in 30% bracket). So if you compare a $100k ROTH to $100k Traditional PLUS $42,000, THAT would be accurate."

This is some horrible math. I am sorry but it just is. No explanation given of how you get to these numbers. They make no sense.

I have a 100K IRA right now. Should I convert it or not? If I do I want to convert the whole thing. So I put it all in a Roth. When I do that in the 30% bracket I must pay 30K in taxes which I pull out of my massively over funded emergency fund. :) Thus 100K in the IRA + 30K extra in a taxable savings fund or 100K in the Roth and no savings fund. That is very straight forward, very basic, and very correct. What you typed above is, I am sorry, a bunch of incomprehensible non-sense. I cannot even fathom how any of those numbers make any sense.

As to the stretch IRA. You seem to be mis-informed. The Roth IRA lets you do the same thing with the added benefit of being able to wait 5 years longer before you start taking any distributions.

See here:

http://www.bankrate.com/brm/news/ira/20041006a2.asp

[Apex]

Keep in mind if you are talking about taking money out of the IRA to pay the tax then you will pay early withdrawal penalties. And while you could do this, it would likely be a bad idea. If you don't have the money set aside to pay the tax it probably doesn't work.

And if you did pull it out of the IRA to pay the tax you wouldn't want to compare that to 42K sitting in a taxable account because thats not where it sits, it used to sit in your IRA.

I think the confusion is you are trying to pay the tax out of the IRA, but then you have the penalty problems. Rather than deal with that you tried to compare by assuming one person had 100K IRA and one had 70K. This is not accurate and its a false comparison. As Savvy originally described it and as I compared above is how it really works. I have already done this. It's exactly what I did. I paid the tax out of extra savings. I did it back in 1998 when they first allowed the conversions and allowed the tax to be spread over 4 years so I got that added benefit too of delaying when I had to pay it. But it works out exactly as described in having 100K in an IRA and then when I am done have 100K in a Roth and 30K less in my savings that I now used to pay the tax on that 100K that was converted to the Roth.

[SJ@6bubbles]

The math issue above makes me sad =(
It's just math ... work it through in variables!!!

The Roth gives you an advantage if you are maxing out your contributions...
However, if you consider putting in 1k/yr pre-tax into both a roth and trad. ira then the tax issue balances out (as claimed above)

In this case of conversion you end up having more money in tax-deferred accounts for withdrawal purposes. So if the 30k was originally being invested elsewhere, you get a better return by converting.

Of course, what happens if 1. tax law changes. 2. 90% bonus tax on IRA withdrawals 3. opps.

Awesome comments apex, savvy!

As for whether the conversion makes sense, erring on caution I think if you have to consider lots and lots of numbers, then it prolly doesn't make much sense, except to provide diversification.
If you are inbetween jobs, in school :D, etc. it's trivially easy to decide.

I like making no money. Makes income tax low and decision to use Roth only great.

One last question, do you need to pay state taxes on the conversion? Your roth contributions are post-state taxed (correct?) And your trad. ira are taxed according to the state you end up residing in?
(Or do I not understand this issue... heh)

[Neal Frankle]

I rounded. Yes. Apex, the differences are indeed minor. Thanks for illustrating that.

I made assumptions. That was in order to make an illustration.

The math is correct. Its the assumptions that you have issue with. You can create any scenario you like and change the assumptions and then argue that the other illustration is incorrect but that of course is flawed logic.

[Jim]

The bottom line is that you can convert an IRA and pay taxes now OR you can let your IRA grow and pay taxes later. So whether or not you should convert an IRA to a RothIRA depends on your individual tax situation. Whether its more beneficial to pay the taxes now or later will depend on the tax rates you pay now versus later.

If your current tax rate is relatively low right now and you expect it to go up, then it might make sense to convert now. If your current tax rate is currently relatively high and you expect it could go down then converting an IRA now doesn't make a ton of sense. If you expect your tax rates to be flat over time then its a wash. The big problem with this decision is that none of us truly has a clue abut what taxes will look like in the future, so its all based on a vague guess.

[Apex]

You are correct that you can use differnt illustrations. However the illustration the savvy and I spell out is the one I always see used. And its the scenario I used when I converted. The reason is because this is the optimal way of doing the conversion. Pulling funds out of the Traditional to pay the taxes is not optimal and if you factored in the early withdrawal penalty its far from optimal.

So I would argue that while your scenario is one you could possibly choose, its not valid to argue Roth conversions are a bad idea by putting up a sub-optimal example as your argument.

Out of curiosity, why did you choose not to illustrate the optimal conversion method that keeps all of your IRA funds in the Roth and show how those numbers work out?

[Neal Frankle]

Apex,

You are right. The scenario I illustrated is probably closer to the scenario in which money is used from the IRA to pay the tax - but post 59 1/2. I also agree with Jim that the decision is situation-dependent.

I was trying to really emphasize that the issue people should look at is 1. the income stream that the two choices create down the road 2. uncertainty with respect to potential law changes and believe it or not 3. my real-world experience that many people defer the tax for generations.

Most people simply look at the ended pot of money and that is a mistake in my opinion.

Your scenarios were closer to those in which folks pay tax outside the IRA.

I should have made that more clear. You and Savvy did me a favor and I'll be much clearer next time. I appreciate it. Thanks guys.

[Apex]

Yeah, we have been kind of getting hung up on this different math scenarios and I certainly agree that the issue of pay taxes now or pay taxes later is not a magic formula with the Roth that gets you way more money. Its mostly a wash as you and others have pointed out. It might result in slightly more money when you factor in the 30K that is growing outside the IRA that is used to pay taxes for the Roth but thats not huge either, so I agree that the rest of the issues are the key issues.

And given the uncertainty of tax law and various other things it seems prudent to have some in each. I plan to.

[Neal Frankle]

Apex. Thanks for hanging in there. You have great insights and I appreciate your attention to the details.

[Lord]

Any comparison is very dependent on assumptions. It is true in the base case there is little difference. How realistic are those assumptions? Will your tax rate be the same? Taxes may rise or fall. Exemptions may change. Most will be in lower tax brackets in retirement, but perhaps not readers of this. Then again they may be overestimating. One can't say from that. If distributions represented only a small portion of retirement income then the same rate may be reasonable, but if it represents most of one's income the comparison would be the marginal rate during work and the gross rate in retirement which would be significantly lower which would make the traditional much better. Also there is the limit to the size of contributions which allows the Roth to accumulate larger deferred amounts which is a consideration if you have maxed out your account. In addition, about half of the benefit of tax deferral is available to passive index taxable accounts. People need to make their best assumptions as to what makes sense to them, but make them as realistic as possible and don't assume you will end up on the Forbes 400.

[Lee]

However the numbers fall it was nice to see a comparison of the traditional and roth ira's. It seems to me that it is always hard to get a fix on a moving target which appears to be the way politicians want it. Too bad for us working stiffs who are trying to plan ahead for our later years. Thank you for the article.

[Tim]

I agree the example was misleading. It was not mentioned that having to take the money out is often the determining factor in whether to do this.

Something else worth mentioning is the 2010 situation with Roths. For 2010 only, the income restriction of $100k is lifted, and you can take TWO YEARS to pay the tax. I plan on making the conversion in Jan 2010, paying some of the tax by April 2011(actually just get less of a refund), and the rest by April 2012. That will keep the principle of the IRA intact.

One other thing to factor in, is the "redo" available with conversions. If my traditional IRA is worth $100k when I convert in January, I'd have to pay $30k in taxes over the two years. But if the value goes down to $75k, I can "redo" the transaction(there is an actual name to this), at the lower rate and pay $22,500 in taxes(at a 30% tax rate). I have done this in the past, and it saved me several thousand dollars.

[Frank]

My biggest issue with this post is that Roth is a guy's name, not an acronym.

And I am really surprised it took 24 comments for somebody to mention a) the reasons why a person might wait until 2010 and b) the redo option. BTW, the lifting of the income ceiling is permanent, not just for 2010.

The choice between Roth and Traditional almost always boils down to tax rates now and when retired. It's really that simple.

[jim]

Anyone who doesn't realize that their taxes will be astronomically higher in the future has their head in the sand, or somewhere else. We will be lucky if the highest tax bracket isn't over 80% in the future. Of course, the gubbament might have no problem taxing the distributions from a Roth in the future, even though taxes have already been paid once. They will need the money, and they will take it because they can, because we elected these idiots.

[Mike]

I'm quite sure that a "Roth conversation" cannot possibly harm you. Whether or not a "Roth conversion" is a good idea is another matter entirely.

As for the future taxation of Roth distributions, it would be a relatively simple matter for the government simply to impose a consumption tax; that way the Roth distributions would be taxed in effect without the government *openly* breaking its promise.

[cmadler]

The explanation that the illustration was of a post 59 1/2 conversion can't be correct, because it then assumed 20 years before withdrawals. If the comparison begins with a conversion at 59 1/2, you'd have RMDs on the Traditional IRA after about 11 years.

[Rob]

Don't kill the messenger. Neal (despite his myopic math and illogical premise, etc.) performed a valuable service by provoking sage rebuttals/corrections/amplifications by Savvy, Apex, Tim, Mike, et al. However, had Neal's errant essay not been an interactive blog, unwary readers would have been dangerously misinformed.

[celgans]

Has anybody considered the fact that if taxes on covertion from a traditional to a Roth were to be paid from a persons savings, (in order to avoid penalties etc), what would be the scenario if the 30K is instead invested in a Roth! Clearly taxes have to be paid, whether now or later and in the assumption (all scenarios depend on assumptions), taxes will not change (which I am 90% certain will be my case, or may be lower). Thanks for the illustration Neal. I think your illustration may apply to some segment of the population and in case it best to discuss with a concrete eg, however, it may be interesting to see the numbers when 100K traditional is converted into 100K Roth but 30K is paid out of savings.
my two cents!