Source: Google from Retirement Planning website
Bulls Make Money, Bears Make Money, Pigs Get Slaughtered”
Nothing is truer than the above when people start to believe they gain an advantage by converting their IRA losers into Roth winners. If you read my previous article on the Myths of Roth IRAs, which you can find here, you may already know the answer. In the light of the new tax laws that have done away with the Roth recharacterization there may be a new emphasis on trying to gain more spendable money in retirement by being concerned with tax-free growth in the Roth. Once again I will show, through demonstration why it doesn’t matter where the growth occurs. What matters is the tax rate you pay on the front end versus the tax rate you pay in retirement when you spend the money.
My wish is not to try and make you an IRS or tax expert but to at least give you enough information for you to understand some of the challenges in trying to navigate the environment of what are called tax-advantaged retirement accounts. In doing so I hope to dispel some myths or at least provoke you to investigate on your own some of the math surrounding these tax-advantaged accounts.
First, some definitions and abbreviations are in order:
I will use the term Roth to indicate any number of what are typically tax-advantaged retirement accounts funded with after-tax dollars for which you can withdraw all contributions and earnings tax-free later. These come in many different forms such as the Roth IRA, Roth 401k, Roth 403b, and others. I will use the term IRA to indicate any number of tax-advantaged retirement accounts funded with pre-tax dollars for which you withdraw all contributions and earnings paying ordinary income tax on them at the time of withdrawal. You could find many types of these such as Traditional IRA, Traditional 401k, 403b, SEP-IRA, 457b, SIMPLE IRA, and others. It should be noted that it is possible to have a mix of after-tax and pre-tax dollars in most of these accounts, but when I use the term IRA from now on, I will only be considering these accounts will all pre-tax dollars in them.
Let’s review what I call the 3 most common levels of tax advantage that you can receive when investing. With the new tax code, it is slightly different now so I will restate it here.
Level one-half: This typically comes out of what is called a taxable account from the generation of long-term capital gains or qualified dividends. Our current progressive tax code gives these gains a reduced tax rate that results in a reduction in the taxes paid. For instance, if your income is otherwise in the 10-12% tax bracket, dividends and long-term capital gains will fall to the 0% tax bracket, until they fill up that bracket. If your qualified dividends and other income are high enough to move you into the 22-35% bracket, the dividends and capital gains will be taxed at 15% for those brackets. I call it level one-half because there is no reduction on taxes for the deposits put in the account to start. The reductions for even the qualified earnings, while some can be essentially tax-free, this only occurs if you keep your total income and earnings below the 22% bracket point.
Level one: This level is occupied by both the IRA and Roth accounts which get either a tax break when you put the money in the account or a tax break when you take the money out. As I explained in my previous article these accounts are on equal footing for equal tax rates in and out.
Level two: This is occupied by the Health Savings Account which is known as the HSA. This account when used properly for medical expenses and accompanied by a high deductible health insurance plan will result in two levels of tax savings, one on the money contributed and a second on the tax-free withdrawals when the money is used for IRS approved medical expenses.
This article is only concerned with the level one retirement accounts and how the IRA and Roth can be thought of in most cases as equals. It is true that the Roth and IRA each have unique characteristics that may be appropriate or at least appealing to different investors. The short list of some of these is described below.
Tax deferral on all earnings inside the Roth if you follow IRS guidelines. Tax-free withdrawal of all contributions and earnings (subject to 5-year holding period plus age restriction of 59½). Tax-free withdrawal of your contributions at any time or age from a Roth IRA. A note on this as it applies to employer sponsored plans is that you should check with your plan administrator as each plan has their own set of rules as to when withdrawals are allowed. Tax planning flexibility – Since there are no forced withdrawals by age 70½, you have more tax-planning flexibility during retirement. If a Roth IRA owner dies, certain of the minimum distribution rules that apply to traditional IRAs will apply to the Roth.
Tax deferral on contributions during working years will lower your taxable income while working and can increase some tax credits. Increasing some tax credits could actually allow you to save more. The required minimum withdrawals must begin prior to April 1st of the year after you turn 70½. The RMD for any year after the year you turn 70½ must be made by December 31st of that later year. If these are not made you can incur a 50% penalty on any amount not taken that was due. Inherited IRAs have a complete set of RMD tables and rules which will not be discussed here.
There are many other nuances to the above two types of accounts and even within different types of Roth or IRA accounts, most of which can be found in the IRS publication 590, which has now been split into two parts – pub 590-A (contributions) and pub 590-B (distributions).
Assumptions for Roth Conversion
In order to make what is commonly called an apples-to-apples comparison of these Roth and IRA accounts we must use the following assumptions:
Because we can never know what future tax rates will be, each evaluation must be done at the same tax rate for each account, both at the start of the test period and the end of the test period. Each evaluation must be done from the aspect of how much money did the investor need to earn to fill the account to begin with. For all evaluations I will assume that the investor earned an extra $10,000 to put towards retirement savings. The tax rate was always 22% now and in the future. That the taxpayer is greater than 59.5 years old so that a penalty-free conversion is possible. See my previous article for how to do this conversion if you are less than 59.5, but why it is exactly equal to what I am illustrating here in an apples-to-apples comparison.
Let’s now continue on to see if we can bust up the notion of why it doesn’t matter how much tax you pay on the conversion, other than the obvious fact that it limits the size of conversion you do.
I lost 40% on my Netflix (NFLX) why not convert it to a Roth and then hope for the best in my Roth.”
Let’s compare some Netflix stock, which lost almost 40% a few years ago and was converted from an IRA to a Roth at that point in time, to what might have happened if no conversion was done. Below are the results.
While you might think that paying lower taxes is an advantage, the math shows that the tax rate in and tax rate out are what is important. Even though by doing the Roth conversion the investor paid $1320 less in lifetime taxes from this investment there was no more spendable income in retirement because of it.
The Roth Revolution
Why do I say Roth conversions are good for the national debt?”
This is easy, according to the Investment Company Institute; there is over $15 trillion in IRAs [including Roths] and other Defined Contribution Plans at this point in time. I don’t know the exact Roth / IRA split of this number, but I am pretty sure it will be leaning towards the IRA side of the equation. With the new lower tax brackets most people can do a Roth conversion for less so they may be considering it, without realizing that how much tax they pay now is not the whole story. However, as in my opening bullet point, this is very good for the national debt. In fact the faster millionaires buy into this strategy the better I believe it will be for all of us. With less debt there is less reason to raise taxes in the future. A Roth conversion is a great way to instantly increase government income. If you have read my many articles and comments on this subject you may know that I am not sure it is best for the average investor. It does have its place and I certainly have always maintained that everyone should have some Roth money to diversify their tax situation in retirement. I just don’t think it should be overdone.
Finally, I will explore what I have seen in some publications as a Fear Of Missing Out of tax-free income in retirement. This FOMO of tax-free income has blinded the investing public to what I have recently called in a comment stream the upside and downside risk of getting your future tax rate wrong. In other words, when we make any investing decision based on future events or tax rates that are unknown it is important to know both your possibility for gains to your spendable retirement income or the losses to your spendable income.
I will illustrate this with a few simple examples that a retiree may see during their lifetime. Let’s start out with case number 1, which is for the high-income earner who wishes to convert a large portion of her sizable IRA into a Roth to pass down to her children. Let’s consider she is doing Roth conversions in the 35% bracket because that is where she has been for most of recent history. Let’s shoot for a tax-free Roth benefit to each child of $1M and compare that to the options of a taxable IRA distribution. The equivalent size of the IRA at a 35% taxable income level is just $1M divided by the decimal created from the subtraction of 1 minus the tax-rate. This math results in $1M / .65 or $1.538 million.
Below is a table indicating the results from case 1 showing both upside and downside risk to their spendable income at different withdrawal tax rates. Assumption is that the beneficiary is married and spouse is not working and there are no investment returns in the life of the inherited account. Positive investment returns would certainly make the dollars larger in the examples but not on a relative or percentage basis. Also there are no state taxes.
As can be seen from the above, the upside risk if you stay with the IRA is about $400,000 (40%) more spending money for someone without a job inheriting the IRA. There is relatively no downside risk at all to staying with the IRA since the original owner converted the Roth in almost the highest marginal bracket. Even if the beneficiary draws the total IRA amount out in one year, the extra $1.538 million only caused the child to pay an effective tax rate of 32.8%.
The above highlights one of the reasons that make the Roth conversion or Roth contribution in higher tax brackets so problematic. Conversion taxes are paid on the marginal income in your highest tax bracket at the time. While the money is also spent in your marginal brackets as well, the starting point of this marginal bracket is usually much lower and can actually start out at zero if your other income is less than the standard deduction. Let’s look at another case in a lower tax bracket while working.
In case #2 the worker wants to end up with the same $1 million in the Roth account but through most of his career his working tax rate averaged 25%. This means to convert to his desired Roth he needs to have $1.333 million in the IRA to convert. Let’s compare the child that inherits the $1 million Roth to the one with the $1.333 million IRA at various spending rates. Below is a table indicating the results from case 2 showing both upside and downside risk to their spendable income at different withdrawal tax rates.
In this case what you see is that the upside to downside risk has changed from a spread of 40% (40% upside to 0% downside) to a spread of 21% upside [gain] to almost 10% downside [loss]. This is still a two to one advantage to the upside.
I will do one final example in which the worker keeps all Roth contributions or conversions in the 15% tax bracket. This case 3 is shown below.
In this final case the upside risk [gain] in staying with the IRA is about 7% for the inherited IRA owner that keeps her AGI within the $101,000 income limit. In the worst case, if the whole IRA is withdrawn in one year while working with an addition $100k taxable income the downside risk [loss] is almost 20% extra in taxes. However, it is highly unlikely that the taxpayer would need to withdraw the whole amount in one year. If the taxpayer keeps her total AGI at the $190k level there is no downside or upside risk and she can draw down the IRA over a number of years.
While RMDs can raise your taxable income and your tax rate in retirement they should not be something that is feared to extremes. In an article I wrote entitled Surviving the Tax Bite of Retirement, I pointed out that over the previous number of years the personal exemption, standard deduction, and the top of each of the tax rate bracket have grown by around 2% per year. With completely revised lower tax brackets for 2018 and the foreseeable future this has only improved the odds of you having a lower tax bracket in retirement, compared to while you were working. Hopefully, you have learned that this favors the IRA owner and the results are not insignificant. Who would not want 10-20% extra money in retirement or for their beneficiaries? I do understand that on the other end you do not want to be seen as the one who increased someone’s taxes with an inheritance. I personally think it is up to you to educate your heirs and make them see that a little bit of tax on a larger sum of many can in many cases be better than no tax on a smaller pool of money.
In my volunteer work helping people with their taxes each season there are always cases where having some of their retirement in a tax-deferred IRA could have resulted in some tax-free withdrawals from that IRA, due to their low income level. The converse is also often true – that with a Roth account it would have been possible to lower how much of their retirement savings goes to the taxman. It is never a bad idea, in my opinion, to have both Roth and IRA funds going into retirement.
For more detailed information on these subjects covered I suggest reading at least a couple of times the two IRS publications mentioned at the outset. Understanding the rules can avoid costly mistakes on the road to retirement as well as later when you are in retirement. I have also written an Instablog article titled Roth Vs. Non Roth (401k, 403b, 457, Etc) & The Time Value Of Money which adds a casino example to the mix that you may find interesting.
I also want to shout out a special thanks to Bruce Miller, who made my job much easier by providing a tax calculator for the new tax law going forward in 2018. He also wrote a good article on the subject which you can find here.
All tax calculations were done using the new 2018 law as best we know at this time.
This study is only as good as the data presented from the sources mentioned in the article, my own calculations, and my ability to apply them. While I have checked results multiple times, I make no further claims and apologize to all if I have misrepresented any of the facts or made any calculation errors.
The information provided here is for educational purposes only. It is not intended to replace your own due diligence or professional financial or tax advice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.