To ROTH or not to ROTH???
Current issue of Journal of Financial Planning contains an article from Edward F. McQuarrie Ph.D., titled Thinking about a ROTH 401(k)?. Think again.
He states that if client’s “Effective” income tax rate is below “Marginal” income tax rate at time of retirement, ROTH investment or conversion absolutely makes no sense. He even projects higher income tax in the future.
I just attended Ed’s 2 day workshop, where he is a strong proponent of ROTH conversion.
Can you comment?
Permalink Submitted by Al Fry on Fri, 2008-07-18 16:38
Income tax rates now and later or even now and after the election are, for the most part a crap shoot.
Permalink Submitted by [email protected] on Fri, 2008-07-18 16:46
That doesn’t exactly answer the question, does it?
Permalink Submitted by Al Fry on Fri, 2008-07-18 19:20
The point being, either Ed may be right. Or wrong. I am in a much higher tax bracket now than when I started my Roths, and also higher than I thought I would be at my age (71). So I am glad I started them 10 years ago. If I had tried to play the “What will my taxes be” game, I might not have started them. What will cap gains rates be in two years? If BO gets in, they may be 28% again. If JM gets in they may stay the same. All I am saying is, everyone must weigh their own comfort level with what the future holds.
Permalink Submitted by Alan Spross on Fri, 2008-07-18 23:54
I read that acticle and still cannot understand why Mc Quarrie uses effective tax rates rather than the marginal rate in retirement. Effective rates are much lower than marginal rates, except for those with huge annual incomes perhaps 3 times that of the top bracket. Another fallacy is failing to recognize how much RMDs escalate later in retirement unless all the IRAs have been annuitized. I really think the guy has an agenda of some sort due to the selective assumptions chosen, some of them incorrect.
One example of these assumptions was that the entire income source was an IRA. Most people have other income sources such as pensions, taxable savings, annuities and SS or rental income. These other sources are there every year regardless of IRA income. The article is worth reading, but again seems to miss some major points.
Permalink Submitted by Bruce Steiner on Sun, 2008-07-20 21:49
The focus of this article was on whether employees should designate their 401(k) contributions as Roth 401(k) contributions (if their employers’ plans so permit). The article is useful, though I and others will be writing more on Roths when Roth conversions become available to IRA owners with income over $100,000 beginning in 2010.
Many employees don’t have the money to contribute $15,500 to a Roth 401(k). That requires much more money than is needed to contribute $15,500 to a regular 401(k). But the focus should be on employees who do have the necessary funds. For them, if they’ll remain in a high tax bracket during retirement, then the Roth makes more sense. In a 40% bracket, contributing $15,500 to a Roth 401(k) is like contributing $25,833 to a regular 401(k), but you’re not permitted to contribute $25,833 to a regular 401(k).
But many employees (even those who have the money to contribute $15,500 to a Roth 401(k)) will be in a lower income tax bracket upon retirement. For them, there is a tradeoff between contributing to a Roth 401(k) to get more money into a tax-free environment sooner, versus contributing to a regular 401(k) and converting to a Roth after they retire, when they may be in a lower income tax bracket (or not converting and paying income tax when the money comes out, possibly over a very long period of time).
It’s difficult to predict future tax rates, especially over a long period of time. The top income tax rate was as high as 91% as recently as the early 1960s, and as low as 28% in 1988-1990. The top rate is now 35% on taxable income over $357,700, but was 39.6% from 1993 until I think 2000. But many people, even many with relatively high incomes, will be in a lower bracket upon retirement. The joint return rates are now 10% up to $16,050, then 15% up to $65,100, then 25% up to $131,450, then 28% up to $200,300, then 33% up to $357,700. My best guess is that in the near term, the top rate might go back to about 40%, but the lower brackets might stay about where they are. But each person should make his or her best guess.
Another factor is state income taxes, which vary from state to state, and if someone retires and moves from one state to another.
Another factor is the beneficiary’s tax rate, for amounts not in a Roth by the time of the surviving spouse’s death. Our clients generally provide for their children in trust rather than outright, and trusts reach the 35% bracket at $10,700 of taxable income. But it’s often easy for trusts to avoid having to pay state income tax in any state.
There are other factors as well. Stay tuned.