Roth conversion questions
I have two questions concerning rollovers from a IRA to a Roth IRA and I’m hoping someone can help. I am always hearing you should never use funds inside your qualified plan to pay the taxes on conversion, thus starts my confusion. If you have funds outside your qualified plan great, you just supercharged your account. However, if you do not have funds outside the qualified plan, why not use the deferred funds inside the plan? After all, the money was never yours, you are just delaying when you have to give it to the government.
I know some will respond with the triple compounding argument. Vanguard did a 2005 study comparing an IRA and a Roth IRA and came to the conclusion there is no benefit from triple compounding. Let’s say you deposit the money in your qualified plan and you are in a 20% tax bracket. You withdraw the funds 20 years later in a 20% tax bracket. Your net spendable income is the same as if you had prepaid the taxes in a Roth. The only benefit of tax deferral is if you know you’ll be in a lower tax bracket at the time a retirement. With our current entitlement program issues, this is highly unlikely.
Next, everyone says you should never pay a penalty to rollover to a Roth. Again, I’m confused. Let’s say you’re a 50-year-old with $100,000 in an IRA, you’re considering a rollover to a Roth and you’re in a 20% tax bracket. You rollover $80,000 penalty free. The $20,000 is withheld to pay the taxes due and you pay a 10% penalty on the $20,000 or $2000. First off, the $20,000 is not a loss, it was never yours in the first place. Second, the $2000 is 10% of the $20,000 but only 2.5% of the $80,000. So, for a 2.5% loss, you just removed $80,000 from the income tax system. All of this holds as long as the $20,000 in additional income does not bump you into a higher tax bracket.
If you are 50 years old, you still have 15 years before retirement. What are the odds of taxes increasing more than 2.5% in the next 15 years? Second, you only need your $80,000 to grow by $2,000 to make up the loss. If you are lucky enough to have your account double to $200,000 in the next 15 years and taxes do not increase (highly unlikely) and your tax bracket drops from 20% to 15% in retirement, you are $13,000 ahead. What am I missing?
Permalink Submitted by Alan Spross on Fri, 2011-03-11 04:07
I agree with you that the pundits should NOT be saying that paying the taxes from the IRA when converting is “never” a good idea. The word never is rarely accurate when discussing either strategy or taxes. They should say that it is USUALLY a bad idea. There are some cases where it is NOT a bad idea, but the characteristics of those situations do not exist very often.
Paying the penalty for the withholding essentially can be illustrated as a higher tax cost for the conversion, although the full penalty only applies if there is no basis in the TIRA. If there is no basis, the penalty will add 2% to the tax cost of the conversion. If your marginal rate is 25% Federal and 5% state, the penalty will increase the total to 32% (higher in CA which also has it’s own state penalty). If you expect a higher rate in retirement than 32%, you still benefit assuming you don’t have the cash outside the IRA to pay the taxes. And you may also benefit even if your retirement rate is the same as you paid on the conversion or within a point or two of it because you gain tax flexibility when you can choose which type of IRA to distribute in a given year in retirement to keep from spilling over to the next bracket.
The other factor here is that you lose 20% of your distribution from either the TIRA or the Roth IRA. Generally bad, but not so if you are retirement account heavy and very light in taxable assets. In that case the loss of a small portion of your retirement account may not have negative results. Another case where it may not be negative is when you can easily replace the amount lost to retirement accounts by increasing contributions to these plans. In that case you end up in the same situation you would have if you paid the conversion taxes from other funds, but then had to reduce your 401k contributions to replenish your taxable assets. You just acted in reverse order and remain in the same position when you are done.
My opinion when considering conversion options tends to lean more heavily on your demonstrated ability to accumulate assets by retirement, both in plans and outside the plans. That is likely to have more affect on whether you end up in a higher bracket than general tax policy. If you can’t save money, then you probably should not be converting at all. If you are a great saver with demonstated success, expect an inheritance etc where you would have increased accumulation, then converting more rather than less is likely advisable.