Saturday, October 30, 2010

Should You Start a ROTH IRA? Maybe Not.

At cocktail parties you may hear a friend of yours say something like, "I just started a Roth IRA - it's a good deal, you should get in on it!" or they may say, "You should think about converting your regular IRA to a Roth IRA!  It is a great deal!"

When you press them for details as to what the advantages and disadvantages of the Roth IRA are, well, these same people get awfully vague.  And if you push further, it turns out a financial adviser told them to do this, and they really aren't sure why it is a good deal, only that the financial adviser said so.

Of course, the financial adviser took a 5% commission when the IRA was converted to a Roth IRA, so yes, it was definitely a good deal for the financial adviser!

Should you start a Roth IRA or convert your existing IRA to a Roth IRA?  Tricky question, as it depends on your circumstances.

What is a Roth IRA?  A traditional IRA is something we all know about.  You put in money when you are working, presumably at a high tax rate, and you get that money deducted from your income, saving on your Federal and State taxes.  When you retire, presumably at a lower rate, you pay ordinary income taxes on the amount you take out.  If you move to Florida, this may mean no State taxes at all!

So the regular IRA is a good deal, as is the 401(k), Simple IRA, Thrift Savings Plan, SEP and CSEP plans.

A Roth IRA reverses the process.  You pay taxes when you contribute the money to the plan, and then can take the money out, tax-free, later on.  How is this different from just a regular after-tax investment, like a savings account?

Well, to begin with, in a regular savings account or after-tax stock investment, you pay taxes on the amount contributed, but have to later on pay taxes on the dividends and capital gains.

For example, say you open an E-Trade account and put in $10,000 and buy stocks with it.  You paid taxes on that $10,000 when you earned it, just as you would with a Roth IRA.  But in addition, each year, you have to pay taxes on the dividends earned from those stocks (if any) and when you sell those stocks, you have to pay capital gains tax on the gains.

With a Roth IRA, you can put the money into a similar account, pay the tax on the initial principle and then completely avoid paying any taxes on the dividends and capital gains.  So you get some tax advantages there.

Is this a good deal?  It can be.  For example, suppose you are young and just starting out.  You don't make a lot of money, so you are in a lower tax bracket -  perhaps the 15% bracket, which would save you only a few hundred dollars on taxes.  Contributing to an IRA really doesn't cut your taxes very much.  But the one advantage you do have is TIME.  Putting $5000 into an IRA at age 20 can turn into $50,000 at retirement if it earns 5% return.  If taxed at 25%, means you owe $12,500 in taxes on an initial $5000 investment.  In this situation, a Roth IRA is not a bad deal, as it would save you a lot of money down the road, in terms of taxes when you retire.

And you can withdraw than $5000 at any time, tax-free.  And even some of the "earnings" might be withdrawn, to use as down payment for a house.  Not a bad deal, if you are young, and in a low tax bracket.

But for older Americans, who are in a higher tax bracket, it may not be such a good deal.

For example, if you are 50 and in the 38% bracket, with the savings in both State and Federal taxes, you may save over $2500 in your tax bill, if you contribute $5000 to your IRA.  In the 15 years between then and retirement, this may grow to $10,000 at 5%, which is not a bad rate of return on what was essentially a $2500 investment.  And when you retire, you pay your lower tax rate (probably 25% or less, particularly if you retire to a State with no income tax) on the proceeds - so you might pay $2500 in taxes, or about what you saved when you put the money in.  The same money invested in a Roth IRA, on the other hand, has no tax savings when invested, so the equivalent investment ($2500, after taxes) is only worth about $5000 upon retirement. Or looking at it another way, if you paid the taxes on a $5000 investment at age 50, you'd have to pony up an additional $2500 in taxes at the time.  While you pay no taxes when you withdraw the money, you paid the highest rate when you put the money in, and don't take advantage of the lower taxes when you retire.

But what about conversion?  You can convert a regular IRA into a Roth IRA, which has some advantages.  However, as in any Roth IRA, taxes have to be paid on the money put into the account.

So if you have $10,000 in an IRA and convert it into a Roth IRA, you have to pay ordinary income taxes on that money.  If you are in the $38% bracket, this means nearly $5000, including State taxes, in some cases.    This Roth Conversion Calculator is an interesting link and also discusses the tax implications.

One problem is that a large conversion (say, $100,000) will definitely push you into a higher tax bracket, resulting a staggering bill for that year.  Now, instead of paying taxes when you take money out at a low tax rate (as with a traditional IRA) you are paying in at the highest rates imaginable.  All I can say is, approach this whole idea with caution, as it could knock out a lot of other tax benefits as well.

The Roth conversion calculator is interesting in that is shows that if you plan on retiring in a lower tax bracket (15%) then it may NOT be worthwhile to convert.  But if you plan on retiring at the same rate you are in now, or higher, then it could be worthwhile and earn you more money as a result.

Each person's situation is specific and you should crank the numbers before making such a conversion.

Note also that another advantage of such a conversion is that after the "seasoning" period (currently 5 years) you can then withdraw contribution money from the account, tax free.  This could be a good way to avoid paying the 10% IRA penalty tax, if you see yourself retiring early (before 59-1/2) and want to have access to your IRA money before then.  But that is a dangerous game to play, because if you start spending your retirement money in your 50's, what will you have left over to spend in your 60's and 70's?

Should I convert one of my IRAs to a Roth IRA?  Let's do the math using the Roth Conversion Calculator.  In one of my Vanguard IRAs, I have $20,000.  Now realistically, this might earn 7% rate of return in the next 15 years.  I am presently in the 28% tax bracket, but expect to retire in the 25% bracket, or less.

The Roth Conversion Calculator is illuminating.

According to the calculator, I should make this conversion.  But, if I went to say, $100,000 (another IRA account) things might change.   Paying taxes on that money would be necessary (and where would I get the money?) and moreover, that declared income would definately knock me into the highest bracket imaginable.

Note also that the equation is based on your current tax rate, your expected rate of return, and your projected tax rate when you retire.  We cannot predict the tax rates when we retire with any certainty, or what our rates of return are.

For a small account, like $10,000 or $20,000, it might be a "good" deal in that you come out ahead when you retire, if all your projections come true.  But you do have to pony up that tax money when you do the conversion.  Adding $3000 to $5000 to your tax bill is never a lot of fun, and if you don't have the cash, well, it just isn't an option, is it?

Second of all, if you convert a large amount of money, it will really knock you into the next bracket, meaning you pay more taxes - and have to pony up a staggering amount of cash for the tax bill.  Converting a smaller amount (like $10,000 or $20,000 shown above) may be more palatable, but the "savings" are also pretty pathetic.  In the example above, less than $2000 at retirement - assuming all your projections work out.

Note also that if you assume a higher rate of return, the Roth conversion seems like a better deal.  But I am not sure we can assume such high rates of return anymore, and moreover, at my age, getting into high risk, high yield stocks doesn't seem like such a swell idea.

So why do some people think doing a Roth IRA conversion is the biggest giveaway in the world?  Again, many of these folks are financial advisers, trying to sell you mutual funds and take a "taste" of you retirement account when you do the conversion.  So it is a good deal for them, maybe not such a good deal for you, and you have a hefty tax bill on the year you do your conversion.

Again, each person's situation is fact-specific, so talk to your tax adviser before making such a conversion.  Don't take tax advice from a financial adviser, and don't take investment advice from a tax adviser!  The IRS code is not an investment guide.

The Roth IRA rollover is another example, I'm afraid, of people hoping to make a lot of money at retirement by making investment choices.  The best and hardest choice to make is to save money and put it aside.  Finagling with your money might make you a little more, but by itself is not going to build wealth.

My personal choice is to study this matter further.  I may open a Roth IRA or do a small conversion.  The idea of having to pay taxes on  $500,000 of income in one year is just not in the cards, though, it I was to convert all of my funds all at once.  At best, I might do a conversion on a smaller account, such as the Vanguard account shown above.  But the net savings may be so minimal, that they would be swallowed up by commissions to the mutual fund salesmen, etc.

Frankly, I think I'd rather put that tax money to work for me in a regular IRA.  Once I am retired, I won't have many monthly expenses (no mortgage) so my income can be reduced voluntarily, to reduce my tax bill accordingly.

But do the math for your own situation.  It may be different.

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