Friday, December 10, 2010

Converting To A Roth IRA? - Part 1

As many of you know, in 2010 the AGI limitation for converting a traditional IRA to a Roth IRA has been removed.  For many lawyers, this means 1) a great of questioning as to whether the lawyer should be converting a traditional IRA into a Roth IRA, or 2) that the lawyer may have their first crack at actually putting any money into a Roth since the program began - due to the income limitations for contributing directly to a Roth that previously existed.

But does it make sense for you to convert to a Roth?  The question is actually best answered in the context of your total IRA and 401K situation.  I'll outline a methodology for determining whether you may want to convert to a Roth IRA below, and then address some concerns about the conversion.  This post got kind of long, so I have broken it into two Parts.

First, we know that there are traditional IRA, Roth IRA, traditional 401K, and Roth 401K.  Your firm may not offer the Roth 401K, it's still pretty new, but it is out there and has no income limitation.  The traditional IRA has also been around for a long time - and has no income restrictions to contribution.  It has income restrictions to deductibility, but you have been able to make a non-deductible contribution to a traditional IRA for some time regardless of income.  Why would you want to do that?  Well, the amount in the IRA is not taxed yearly like a standard investment account would be.  For example, investing in a stock with dividends?  With a regular investment account you would have to pay taxes on the dividends every year, but no taxes would be due until withdrawal with the traditional IRA - at which time you would pay taxes as ordinary income.

When you leave employment, you have the option (and most exercise it) of converting a traditional 401K to a traditional IRA and a Roth 401K to a Roth IRA.  At that point, the main difference between the two programs is either that you had to pay the taxes upfront for the Roth IRA and Roth 401K and consequently will not be taxed on withdrawal - or if you typically did not pay taxes on the traditional IRA (for most people) and 401K, for which you would be taxed at ordinary income rates.

The first question to ask is "what do I want my contributions of Roth-style payout to traditional-style payout to be in retirement so as to mzximize my income in retirement?"  Recall that there are no taxes on Roths at withdrawal, but because you pay taxes on them up front, there is typically less in the investment account.  For example, if you are contributing to a 401K and contribute $15K pretax, then you will have $15K in the traditional 401K account, but (assuming a combined federal and state tax rate of 40%) you will only have $9K in the Roth 401K.  Both accounts will then grow tax deferred - and should grow at the same rate, so for the same "real-dollar" contribution, you are going to have a lot more in the traditional account than the Roth account.  For example, over 30 years at 8%, you will have about $150K in the traditional 401K, but only 90K in the Roth 401K.

Many people might immediately assume that they want to put everything in the Roth account, but that does not maximize their financial benefit.  They make this assumption because they figure that "their tax rate will be higher in retirement".  However, that assumption is unlikely - or at least not inescapable - even if they are living a reasonably high lifestyle.  For example, in retirement your house may be paid off and your kid-associated expenses may be low because they are most likely out of the hosue and done with college.  Additionally, you may be receiving tax-free income from investments in municipal bonds, real estate depreciation, social security (mostly non-taxed as described below) or withdrawals from a Roth plan.  Also, realize that in 2010, for example, if you are married filing jointly, you can recognize up to $68,000/year and still be in the 15% tax bracket!  Think about that for a minute - if your mortgage was paid off and you had no kid-associated expenses, you could live pretty darn well on $5500/month in most areas of the country.  That is, you can have a pretty decent lifestyle in retirement without leaving the 15% tax bracket.

Consequently, you could recognize $68K from a regular IRA - and then if you need more income to support your lifestyle, you could supplement it with withdrawals from a Roth, muni bond income, or real estate income.  Conversely, many of the "comparisons" for the Roth IRA overlook this aspect and project much higher tax rate in withdrawal.  I agree with those projections that the Roth IRA would be slightly better in the long run - but only if you failed to plan and were forced to take traditional IRA income at about 33% rather than 15%.

Conversely, if you can keep the tax rate on the IRA withdrawals to 15%, every projection that I run puts you way, way ahead of the Roth IRA - because you can put more into the account in the first place for the same "cost" to you.  To put it another way, most of the projections that I see represent an apples-to-oranges comparison because they start out with the same amount in Roth and traditional IRA.  Certainly, if you start out with $9K in both a Roth and traditional, then you will be better off with the Roth because there will be no tax at the back end.  However, that's really an apples-to-oranges comparison because getting that $9K into the Roth cost you $15K (pretax) while getting that $9K into the traditional cost you only $9K.  If instead you compared the eventual in-pocket for the real equivalents (9K Roth, 15K traditional, both grow at same rate) using only the 15% tax on the traditional, then the traditional leaves the Roth in the dust.

For example, over 30 years at 8% we saw that the traditional grows from $15K to $150K and the Roth grows from $9K to $90K.  Giving the traditional IRA a 15% haircut reduces it to $127,500 - which is still far ahead of the $90K.  In fact, the $127.5K is about 42% more than $90K.  (Obviously, you would be limited to taking only $68K/year, but this example is for the sake of simplicity).  We certainly don't want to leave that on the table.

More discussion and practical advice in Part 2!

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