I have so many exciting things to talk about this month, I was having trouble deciding which to choose for my topic in this space, but since I had three different people ask about taxes and roth conversions in the past week, I thought I would write on the exhilarating topic of taxes!
I know this may be dull as dishwater for you, but it does answer a question that many seem to have these days.
Here we go…
Many Financial Advisors recommend the conversion of Traditional IRA accounts to Roth IRA accounts because “tax-free” is much better than “tax-deferred.” While this statement is undoubtedly true, it distorts the criteria we must use when deciding to convert or not.
The real question is, “What will my tax rate be when I pay my Traditional IRA withdrawal taxes?
Let me give an example to explain. Would you rather pay $10 in taxes or $100 in taxes? Duh, easy one, but not so fast. The missing detail in my question is this: your tax bracket is 10% in both cases. In the first cast wherein you pay $100 in taxes, you withdraw $1,000 today from your IRA, In the second case, you withdraw $10,000 from your IRA in the distant future if your IRA has increased ten-fold, The answer, then, is that it doesn’t matter. You have paid the same proportional value from your IRA in taxes.
I will explain further.
As we learned in junior high math, the Commutative Property of multiplication states the order in which we multiply numbers does not matter: i.e., x*y*z =z*y*x
If we let d = our initial deposit into the IRA, r = the return over several years, and t = the tax bracket, then assuming that t stays constant, then t*d*r = r*d*t. So it doesn’t matter to your final outcome if t, the tax rate, remains constant.
This concept is a fallacy I see taught everywhere. The Roth does not hold an inherent tax advantage over a traditional IRA unless tax rates are lower in retirement than when working. I tell people the fundamental question about Roth vs. Traditional IRA & Which is Better; all boils down to what tax rates will be in the future. Will they be higher when retirees investors withdraw from their IRAs? There is a strong case today (Federal debt & growing entitlements) for the answer to be yes. The case for your tax rate is lower is simple: most of us will have much less taxable income in retirement as opposed to our working years.
Proposed tax increases and proposed tax cuts come and go, so what are we to do about this issue?
In general, I recommend investors diversify their holdings to reduce risk. You know this from our many discussions and the different mutual funds and assets classes you hold in your accounts. However, just as I recommend diversifying asset allocations, I also recommend diversifying investment accounts from a tax-treatment standpoint.
This, however, is easier said than done for working people, given the restrictions on Roth IRA contributions until the recent advent of the Roth 401k, If you have that option available at your workplace, you may wish to consider dividing your contribution between the Roth and the Traditional.
Full Disclosure: I do not contribute to a Roth 401k; 100% of my contribution goes to a traditional (tax-deferred, not tax-free) 401k because I believe my tax bracket will be lower rather than higher in retirement, I also offer the caveat that my prediction of the future is very hazy, and I don’t have a clue what may happen in 20 to 30 years.
Fuller Disclosure: I also take advantage of what is known as a “backdoor Roth conversion,” which allows me to put $7000/year into a Traditional IRA as a non-deductible contribution and then convert that to a Roth IRA. That opportunity may go away in 2022 based upon potential changes to tax laws.
I promise to return to my usual irreverence and what I call “wit” embedded in a bit of story-telling next month, Till then…
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. The hypothetical examples provided are not representative of any specific investment. Your results may vary. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. No strategy assures success or protects against loss. Investing involves risk including loss of principal.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 1⁄2 may result in a 10% IRS penalty tax in addition to current income tax.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 1⁄2 or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.