Jul 21

If you read any financial blogs or magazines, there’s no getting away from one topic. The Roth IRA, and the Roth conversion in particular. I continue to write about this because I think the choice isn’t always so clear cut. It’s rarely a “no-brainer” to convert and be certain it was the right decision.

I read and recently rediscovered an article in Kiplinger magazine titled “How to Finance a Roth Conversion.” Sorry, that title alone is enough to scare me. It implies a number of things. First, this couple in the article aren’t particularly liquid, they don’t have enough to pay the taxes on the conversion out of pocket. Second, they plan to convert so much that there will be a big tax bill. In fact, the amount they are considering converting is $250K, and it will result in a $100K tax bill, putting them into the 35% bracket. One planner advises that they proceed with the conversion splitting the income over two years on their tax return. This would make the first bill (say $50K) due in April 2012. He says they need to just save about $2K/mo from now until then, to pay this tax bill. He ignores the potential penalty and interest for underwithholding, and does a better job ignoring the next $50K bill that would be due only 12 months later.

Another planner thinks this couple should convert a bit at a time and pay [taxes] as they go. A more level-headed approach I’d say.

For this couple, the question of conversion is motivated by “higher taxes are coming.” Now, that may be, I really can’t say. One thing that does go in this couple’s favor is that they are both government employees. They are in a group that tends to have a better pension than most. Many public companies have discontinued their defined benefit plan, in some cases stopping further accrual, in others, cashing out their employees with a transfer to an IRA account. The question that remains for me regarding this couple, who are in their thirties and have an infant daughter – what do thing the chances are that you will both remain employed, full time, from now until the day you retire? Robert Burns’ To a Mouse contained the line “The best laid schemes o’ mice an’ men / Gang aft agley.” I wish this couple well, but a lower bracket between now and retirement isn’t necessarily due to a negative event. Maybe one of them wishes to stay home for a period after the birth of their next child. Maybe a new position becomes available in a state that has no income tax and they avoid the near 6% Virginia state tax. Time will tell, of course, this is just one example of those who are rushing into a decision I believe they’ll regret. Next week, I’ll offer an alternate approach that would save this couple quite a bit on their taxes.

Joe

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Jan 24

I’ve been reading and writing about Roth IRAs for some time now, and it’s time for a Roth Roundup, from both fellow bloggers and the usual sources.

Amusing Juxtaposition
Creative Commons License photo credit: therefromhere

First, let’s start with How to Convert Traditional IRA to Roth, at 70½ a question posed at the Wall Street Journal. A fellow whose mom is turning 70½ in ’10 is asking how to “shield her mandatory withdrawals from future taxes on earnings.”  He has calculated the first RMD at $30,000, implying a gross pretax IRA of about $822,000. The reply, which floored me, was to convert it all this year to a Roth, and not worry about taxes again. Wow, send mom into the 35% for the next two years instead of converting over time? Sorry, I can’t imagine much worse advice. (And a comment there pointed this out)

Nickel wrote about Tax Diversification When Investing, a level-headed approach which straddles both the Traditional IRA and Roth to hedge one’s bet as to what their future situation will be. Mike at The Oblivious Investor wrote Tax Diversification: Roth IRA vs. Traditional IRA, a very similar post advocating a mix of account types.

Bad Money Advice asks Why are Roth IRAs so Confusing? Indeed. He shares my disdain for the bad advice out there advocating wholesale conversions with no qualification. In this article we’re shown the commutative property of multiplication, the fact that multiplying by .75 (to reflect a 25% tax rate) before deposit or after withdrawal leads to the same result. Another easy to understand way of looking at this issue.

JJ guest posted on Consumerism Commentary with 2010 Roth Conversion: Good Idea? A nice overview of the pros and cons of a conversion, covering a number of issues others may have overlooked: The non-deducted contributions, estate planning concerns, wholesale changes to the tax structure among them.

Robert Horowitz warns us to Beware the Roth IRA or at least the hype around it. While Robert doesn’t go into the dry boring math that I so enjoy sharing, he does offer a punchline similar to what I’ve been preaching, that “If you retire with no more than $5 million in investments including IRA’s – your federal marginal tax rate probably won’t be much more than 15%. Rates would need to go up dramatically before conversion makes sense.”

Next, we have Charlie Farrell’s Don’t Rush Into Roth IRA Conversions. Charlie also isn’t caught up in the Roth excitement, instead looking at the difference between a lump sum conversion today vs small taxable withdrawals later. His focus is that it’s tough to be confident that you’ll be in a higher tax bracket at retirement, and I agree with this position. Charlie is the author of Your Money Ratios which I reviewed here recently.

Robert Powell of MarketWatch wrote two pieces, Roth it right, Six mistakes to avoid when converting to a Roth IRA and Rethink that Roth 12 traps to avoid when converting to a Roth IRA. A lot of information here, worth reading very slowly. It’s not that a Roth is bad, just that it’s not the slam dunk some would claim it is. Many things to consider, and for many, jumping in to a Roth can be as costly as not Rothing for one who should.

Sam at Financial Samurai tells why you should Be A Sloth and Don’t ROTH – Why Converting To A ROTH Is A Mistake! It’s obvious from this post that Sam is a numbers guy as am I. He’s done the math and says that “To replicate $100,000 in income, you will have to have at least 25X your income in capital, or $2.5 million at a 4% risk free return to produce $100,000/year!” He also makes the point that one can potentially move to a state with no income tax at retirement, thereby saving 5-10% then instead of worrying about rates now. A good read and great series of comments by many including yours truly.

Last, in my role as staff writer at Jeff Rose’ Good Financial Cents, he’s published my Using a Roth IRA to Maximize Your Wealth and this past week, Unforeseen Consequences of the Roth IRA Conversion. Jeff has been pretty prolific on this topic as well, Roth IRA Rules For Minors. Your Kids Guide to Tax Free Money and Choosing Between Traditional Vs. Roth 401(k)s among his recent writing.

The message in all of these articles is that it’s not a ‘no-brainer.’ The decision to use a Roth, Roth 401(k) or the rules to convert are an individual decision, and there’s much to be considered. Do the math, take your time, and ask questions. Most of the articles cited here are from bloggers who are more than happy to keep the dialog going.

Joe

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Nov 22

I must say, I enjoy the Sunday round-up posts. It keeps me open to new ideas and on the lookout for fresh blogs. I try to bookmark one or two articles each day and then on Saturday review my collection. Right until now I don’t know how many will past final edit. Let’s get started and see my weekly finds.

Benjamin Clark posted at Christian PF, What are Charitable Gift Annuities and how do they work? It turn out they offer a way to get a tax deduction, immediately, then get a steady income while also do good (donating to a charity.) The downside, if there is one, is that upon your death, the charity picks up the remaining value of the funds, no money is left for your heirs.

The Psychology of Bubbles: Using Hindsight to Examine Why We Bought into the Hype is an excellent, in depth, discussion of bubbles and their cause posted at Steadfast Finances. He includes a chart of the stages of a forming and then crashing bubble, as well as discussions of the bubbles of the most recent ten years, tech, oil, and housing. Excellent post, worth your time.

Similar to the oft repeated message we hear about achieving prosperity, but worth reading is 5 reasons you are not wealthy. One day, these behaviors will be obvious enough that we’ll learn to avoid them, and get on track. Maybe.

Investopedia’s Amy Bell posted Overcoming 5 Major retirement Risks. One Risk is that you might outlive your cash. Amy offers suggestion on how to overcome this risk and four others in this article.

For some time I’ve been trying to get the word out that the Roth conversion will benefit a select few at any time. Now, Susan Tompor of Freep.com agrees that Roth IRA conversion isn’t for everyone. Of course there are many factors to consider, but Susan reminds us that if you don’t have the cash handy to pay the tax upon conversion, it’s never a good idea. The rules kick in in just about 6 weeks, what are your plans?

And to close out this week’s reading – The oblivious investor again shows us he’s anything but, his Efficient Market Hypothesis: Strong, Semi-Strong, and Weak is a great paper on a topic we usually run into in a college level finance class. This theory basically states that the current price of a stock represents all know data available on that stock at that given point in time. Theory vs reality, I suppose.

Another good week. Four days till turkey.
Joe

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Nov 12

Jeff Rose is a Certified Financial Planner who maintains a blog at Good Financial Cents. Jeff invited me to provide a regular guest post at his blog an I am honored to have the opportunity. The first of these posts Rules and Limits for the Traditional IRA is now up and I invite you to visit and read that article. With all the hype around the Roth IRA and the upcoming (2010) conversion rules change, the traditional IRA shouldn’t be overlooked.

Joe

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Dec 12

On an internet usenet group misc.invest.financial-plan, I recently commented on a question and I’d like to share this with my readers:

Q: When the stock market is in the toilet, why don’t we hear more recommendations for converting traditional IRA’s to Roths? It’s the perfect time for it because it minimizes your taxes.

A: Because when you do the math, the state of the market is not so relevant. Here’s my thought, illustrated.

You have $10000 in the IRA, and convert to Roth, paying $2500 in tax (out of other funds)
Decades later you have 10X your money, $100,000 in the Roth.

I have $10000, but take the extra $3333 (which is $2500, pretax) and add it to my pretax IRA or 401(k).
Decades later, I have $133,333 which can be $100K after tax (if taxed at 25%)

The conversion has far less to do with the $10K having been $20K last year, and more to do with:
A) current bracket
B) future bracket
C) estate concerns, including kid’s brackets.

It’s usually a good idea to use Roth conversions to “top off” your current bracket, whether while working or in retirement, if you fearing higher marginal rates later on. Multiple discussions I’ve joined on this topic most often end up ignoring the relative value of the portfolio vs recent past.
One other point I’d offer; I’ve discussed the “pre-tax vs post-tax” debate, and one needs to look carefully at their present marginal rate right now compared to their average rate at retirement. Only those who expect to retire with quite a high balance would benefit from the wholesale shifting of funds over to Roth.

Joe

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