I read quite a few financial magazines, and follow the financial writing of countless finance bloggers. Recently, there seems to be a growing mania surrounding the Roth IRA (and the Roth 401(k) for that matter) as well as the chance to convert money to a Roth with no income restriction next year. I wrote about this last year in two posts titled Loving That Roth and More Roth Lovin’. It’s time to refine and repeat the message regarding this flavor of retirement account. We need to start with one understanding. Your Marginal Tax Rate, what is it, and how do you figure it out?
Next, what is the source of the Roth Mania? The idea that you’ll be in a higher tax rate at retirement, right? With no other income (e.g. pension) how much can you have in pretax accounts and still pay no tax at all, zero? In 2009, a married couple had a standard deduction of $11,400, and two exemptions $3650 each. This totals $18,700. So far, it’s just adding three numbers. Now, some patience, please. Most planners suggest you only withdraw 4% of your retirement balance each year as a safe number. More and you run the risk of depleting the account. So, 4% of $467,500 is our $18,700. You can have nearly $500,000 and still be in the zero bracket! The next $16,700 would be taxed at 10%, and it would take $417,500 to produce that $16,700. I’m going to stop right there. Too many numbers and my readers lose interest, I know.
Let me sum up the above paragraph: You can have as much as $885,000 in pretax accounts, and the withdrawals will not even put you into the 15% bracket. These are today’s dollars, the numbers continue to shift up with inflation. To illustrate the impact of the shift over time, in 2004, the standard deduction and exemptions added to $15,900, which would be supported by $397,500. The 10% bracket was taxable income of $14,300 supported by $357,500. So, just five years ago the total was $755,000. Can you know today what this number will be in five more years, or twenty? Nope, you sure can’t. But you know today’s number, and whether you are anywhere near it now.
When does it make sense to convert? If you were making deposits to your IRA but earned too much to be able to take a deduction, you can convert and only pay tax on the appreciation within the account. You need to review the numbers to see if this makes sense for you.
It can also make sense to convert some IRA money to Roth once you are retired and understand where you fall within your bracket. For example, if you are married filing joint your taxable income from $16,700 to $67,900 is taxed at 15%. Say you see that you’ll be at $40,000, you should consider paying the tax and converting $27,900. I call this “topping off your bracket,” and it’s a great way to reduce your future RMDs (required minimum distributions) so the increasing amount you are forced to withdraw doesn’t bump you to a higher bracket.
Who should deposit into a Roth? Young people working part time or just starting a job, likely in a low bracket and not a bad idea to just pay the 10% or even 15% and put that money away. The other exception is truly an exception in these times, those who have an excellent defined benefit pension plan. The old fashioned plans were structured to replace a large portion of your income, 80% wasn’t unheard of. So, my remarks above aside, if you are well into your working career and will enjoy such a pension, and still are saving in a retirement account, the Roth is something you should really consider.
In the end, the decision is yours to make. Don’t get caught up in the hype, a conversion for working people may be right for a very few people, not the majority. I’d hate to see people jumping on the conversion bandwagon, paying 25% or 28% to convert only to discover they retire and are in the 10% or 15% bracket. That would hurt.