Sunday, December 8, 2019

Convert to a Roth IRA? Or Live Debt-Free?

A Roth IRA might be a good idea if you plan on having a lot of taxable income in retirement.  For most of us, this isn't an issue!

A reader (accountant) writes:
Strategic planning for Roth IRA conversions can have a huge payoff as well. Years ago, I had a general contractor client who had a really bad year. He did a Roth conversion, which required picking up the converted funds as taxable income. However, that was offset by his business losses. So, he had the benefit of tax deductions when he contributed to the IRA in the past, and will enjoy tax free Roth IRA withdrawals in the future. 
I never thought of this before, which is why, if you do make a lot of money or run your own business, having a good accountant is a good idea.  I have had three, in my lifetime, two great, and one utterly evil.   Like anything else, there are the good and bad.  Caveat Emptor.

The scenario described above sounds interesting.   If you have a huge business loss one year and don't want to carry it over, you can convert some of your traditional IRA money to a Roth IRA and the business losses offset the taxable "income" and you can do the conversion tax-free.

Of course, an even better scenario would be to have a better year and not have huge losses that need to be offset.   But if you have such losses, it beats carrying them forward, which has its limits.

I wrote about Roth IRAs before and for the most part, I don't think they apply to my station in life, or for that matter, most folks.  A lot of us hear about them, or hear someone mention it at a cocktail party and then wonder, "Gee, am I missing out on all this free money from Uncle Sam?"

Maybe.  Maybe not.   There are two approaches to retirement, in my opinion.  The traditional pensioners get big checks from their former employers - often close to what they were making in their last years of working - as well as social security.  Their financial lives, post-retirement, are similar to their pre-retirement lives.   They get big paychecks, pay big taxes, and seek out big tax loopholes, or as we call them, tax deductions and tax credits.

In their minds, it "makes sense" to have a mortgage, as you can deduct the interest and reduce your taxable income.  And since they get a steady stream of checks every month, borrowing money to buy a car - or to even go on vacation - makes "sense" as they have income but no wealth.  As one former government employee friend of mine admitted, he and his wife are raking in six figures in pension, but have little more than $30,000 in the bank - and are fully mortgaged to the hilt.  And their cars are all financed at the Navy Federal Credit Union.

That sort of "makes sense" for them, although in real terms they would be wealthier if they had no debt - but that ship has sailed already.   For them, a Roth IRA has the advantage of being tax-free in retirement, so if they had that $30,000 in a Roth IRA, they could spend it, tax-free.   Of course, the point is moot - in the greater scheme of things, thirty grand is a drop in the bucket.

For schmucks like me, who retired with this 401(k)/IRA deal, there is no pension plan, and Social Security is years away - perhaps a decade.   I have to live on my savings, which means spending as little as possible.   Moreover, since I am on the Obamacare plan, the more I "make" in taxable income, the more I pay in health insurance premiums.   The system is set up to encourage me to make as little as possible.   Since I have after-tax savings to live on, I have to be careful to make sure I have at least $25,000 in taxable income every year, so I don't lose my Obamacare plan.   It is a strange set of incentives - and illustrates why government incentives can go off the rails.

But more than that, it is an issue of retiring with or without debt.   My government friends can sustain debt in retirement, and maybe there are some advantages to that.  Of course, they have government pensions, which are pretty secure.  I am not sure that someone with a pension from Sears would be as relaxed.

But for me, if I was to service debt on my home, car, and whatnot, I would have to take out a lot more money from my IRA every month to pay for this.   This would mean having a higher taxable income.  Now, granted, the Roth IRA would eliminate this tax problem (but create a new problem with Obamacare - I would have to get a job to realize some income to qualify!).   But the big deal is, I would have to withdraw at a rate twice as high as I am now, in order to get by.   As a result, I would end up draining my IRA that much faster and would end up broke before I passed on.

But wait, it gets better.

Since I don't need thousands of extra dollars a month to pay a mortgage, my taxable income is laughably low.  So low, in fact, that my net tax bill is effectively zero for the last few years.   You read that right, zero.  If you are making, as a married couple, only $25,000 a year, your tax liability, after the standard deduction and whatnot, drops to little or nothing.

So the tax advantage of the Roth IRA, for me, is non-existent.    I'm already not paying any taxes as it is.  Can't get much lower than zero.

But of course, all of this is predicated on my being debt-free.  If I had a mortgage to pay, then I would be draining that IRA pretty quickly, not only to pay the mortgage every month, but to pay the tax bill on the additional income (nearly double) to support that debt servicing.

A lot of people don't think about this, in terms of being debt-free.  "You can get a deduction for interest!" my (former) Fidelity manager advises.    And if I had a six-figure income, yea, that would be nice.   But since I don't have to make mortgage payments, I don't need a big income, hence I have a non-existent tax bill, which is a greater savings that any potential mortgage interest deduction.

That, and I don't have to drain the IRA every month to pay a bank interest and principle. And the relaxed feeling one has in being debt-free and not having the debt monkey on you back for life.

The Roth IRA is an interesting beast.  But I am not sure it would have really worked for me in my lifetime.   If I had a large taxable income in retirement, then it would have been a good thing.   But for me, that question is moot - we simply don't have that kind of savings to support a large income in retirement, and no "pension plan" that would be taxable.