This is a continuation of Part 1 with regard to Converting to Roth IRA.
So what does this mean for our planning? It means that we want to have BOTH Roth-style investments and traditional-style investments. More precisely, we would like to retire with traditional-style assets that would provide us with enough income to stay within the 15% bracket, but then Roth-style investments that we can pull from if we need more than that. What are the exact numbers? Depends on your age, lifestyle, living expenses, how long you have to retirement so that you can estimate how they will grow, etc.. However, here are some general considerations:
1) If you have not yet made any retirement contributions and you won't have any other source of taxable income in retirement, your first contributions should be to a traditional, rather than a Roth. This is because if the traditional IRA is your sole source of income in retirement and it is not big, then your total income is unlikely to exceed the $68K 15% income tax rate. (Another thing that people sometimes take into account is taxation on Social Security Income - from $32-$44K, you have to pay income tax on 50% of your Social security benefit - over $44K 85% of your SS benefits are included in taxable income. But then who knows what SS is going to do over the next 30 years. Include it if you want to.)
2) If you have $1M in your traditional IRA, then you should most likely put all of your contributions toward the Roth-style investment. This is because you will already most likely be exceeding the 15% bracket - especially with the yearly required minimum distributions that you will be required to take from your traditional IRA.
3) What if you are between these two end cases? Let's say you are 35 years old and have $100K in traditional-style assets (IRA or 401K) and $100K in Roth-style assets, and are married. Let's say that you will retire at 65 and live to 85 and you want to have enough in traditional style-assets to allow you to pull out $68K/year for each of those years. Well, using this simple annuity calculator, we find that we want to have about $721K in traditional-style assets at retirement (assuming an 8% rate of return). According to this little calculator our current $100K (assuming 8% return) at 65 will be more than enough. However, if we adjust the $68K for inflation, say 3%/year, then we will really be wanting $165K/year - and we would need about $1.75M when we retire - and we would need another $60K in value today for the account to grow into the $1.75M that we want. Consequently, we would get more bang-for-the-buck by investing in a traditional IRA/401K, at least until that number is reached.
4) We may not be able to completely control the characterization of a retirement contribution as traditional or roth. For example, many firms may provide matching or other contributions to an employee 401K. However, these contributions are almost always provided to the traditional-style 401K rather than the Roth-style 401K - even if the employee is contributing to the Roth 401K. That is, if you make a Roth 401K contribution, usually the "firm match" goes into your traditional 401K account. Consequently, the employee is going to get some traditional-style contributions even if the employee wants Roth-style contributions.
In actuality, at least at the partner level, many firms are structured so that the partners maximize the employer contribution to the 401K in order to save on taxes. This is not a windfall to the partners because the amount contributed by the employer is usually subtracted from the partner's other compensation. However, because the total of all contributions in 2010 was $49K and the total of employee contributions was $16.5K, a partner in such a situation may be putting $16.5K into the Roth 401K, but the remaining $32.5K is going to go in a traditional 401K. Consequently, in such a situation, the person may wish to adjust their relative contributions to Roth vs. non-Roth accordingly.
Bottom line - start with the Regular 401K until you have reached a threshold that puts you close to your desired number to stay inside the 15% bracket at retirement. If you have extra money at that time, and you can deduct it - then go for a traditional IRA. Other than that, if you have extra money that you want to put away you will have to pay tax on it whether it goes to Roth or traditional IRA, so it might as well go to Roth (if we can). If you exceed the income limitation for contributing directly to a Roth, then contribute to a traditional and then roll it over.
However, if you run the analysis above and you find out that you already meet your number at the top end of the 15% bracket, then all of your contributions should be directed to Roth-style investments rather than traditional, if possible.
Further, if you have traditional IRAs that put you in excess of your number and you have the resources to pay the taxes, then you will likely be better off doing the conversion from traditional to Roth this year (sooner rather than later) because the tax rates are eventually going to go up - and every year the account (typically) makes more money - which will be taxed in a future conversion.
A word about conversion - if you have been making pre-tax contributions to a traditional IRA, you have a special benefit and a special limitation. The limitation is that you must convert all of your IRAs at the same time. The special benefit is that you only pay tax on the investment return rather than your original basis. For example, if you made a $5K non-deductible contribution, but it grew to $6K, then you would only pay tax on the $1K in gain (not the whole $6K) when converting to a Roth IRA.
Additionally, if you convert in 2010, you get the special benefit of being able to either 1) pay 100% of the taxes on your 2010 return, or 2) being able to pay 50% of the taxes on your 2011 return and 50% on your 2012 return.
For myself personally, I did the analysis above and found that my traditional 401K assets exceed the projected number to remain in the 15% bracket at retirement. Consequently, all of my new 401K contributions are directed toward Roth-style investments (where possible) - and I converted all of my traditional IRAs to Roth. I had been contributing to a non-deductible traditional IRA for many years and had never been eligible for a Roth IRA. I had also been contributing to a non-deductible spousal IRA, and converted that to Roth IRA as well.
In terms of paying the taxes on the conversion, if you had asked me earlier this year I would have been certain that the Bush tax rates would be "no more" for 2011 and consequently I would have advocated taking 100% in 2010 for most cases. Now I am uncertain as to whether the compromise will go through - but it looks like it will. If the tax compromise goes through and it freezes my tax rates for 2011 and 2012, then I will most likely delay paying the tax on the conversion until 2011 and 2012.
Here are some other good articles with regard to the traditional to Roth IRA conversion:
1) This article includes an example noting that the conversion is not advantageous if you are converting a traditional IRA that would have been taxed at 15%.
2) A good article from Bankrate.
3) From the NYTimes earlier this year - part of a series.
Hope that helps! I'll look forward to your questions in the Comments!
Thanks for this post. I had been wondering what to do. I max out my 401K and try and max out my Traditional IRA as well. I am unable to claim a deduction on the IRA so it is good to know that I should be contributing to a Traditional and converting to ROTH IRA. I'll have to figure out how to do that. Thanks for the guidance.ReplyDelete
1:36 - You got it. The conversion is usually pretty simple. For many services, you can just convert online. Here's the link for Vanguard's online conversionReplyDelete
For other services, you may have to open a new account or send in a form. I recommend that you get on it this week in case there is an issue, so that you have time to resolve it. Good luck!