TIME TO TALK ABOUT ROTH CONVERSIONS

[Atash Hagmahani]

For those of you in the USA:

I think the income cap on converting IRA and 401(k) accounts is off this year. This is the year it's easy to convert.

Meg?

For those who don't understand why you would want to: if you're reasonably young, it is a GIGANTIC tax savings, because YOUR EARNINGS are never taxed when distributed. Over time, YOUR ACCUMULATED EARNINGS will become MOST of your nest egg.

It seems to me it is also a gigantic savings of time and accounting, because you are taxed once, up front, instead of many years down the road.

Be aware that rules are subject to change--the most likely candidate is a national VAT/sales tax, to tax it when you SPEND it.

[MountainMeg]

That's correct.  From publication 590 (www.irs.gov)

Conversions to Roth IRAs. Beginning in 2010, the modified AGI and filing status requirements for converting a traditional IRA to a Roth IRA are eliminated.Also, for any 2010 rollover from an IRA other than a Roth IRA to a Roth IRA, any amounts that would be included as income will be included in income in equal amounts in 2011 and 2012. You can choose to include the entire amount in income in 2010.

Which means you can do a conversion no matter what your income.  You also have the choice of paying the income tax on the amount converted fully in 2010 or dividing it up over 3 years (2010-2012).

[Atash Hagmahani]

Thanks, Meg. I've started the process for converting a small IRA I have, that has been a nuisance to maintain as separate from my Roth.

I might go ahead and pay the whole thing up front, in order to intentionally make myself less cash rich, just in case it will help my son's chances for financial aid, which I seriously doubt it will. 

[tigger]

I have three comments/questions so I'll post each individually.

The first is a recent article from Motley Fool:
"Why You Should Convert to a Roth Right Now"
http://www.fool.com/retirement/iras/2010/01/06/why-you-should-convert-to-a-roth-right-now.aspx

The short story is that even if you convert, you can change your mind and undo it in the future (within a certain timeframe).

[tigger]

The next is the age old tax now / tax later question.

I'm of the opinion that I like the Roth IRA because it removes unknowns.  You pay tax up front and then what's left is "what you see is what you get".  (The Roth has other advantages like ability to withdraw the principal.)  In a 401k (or any not-yet-taxed retirement account), for comparison, I think there are two disadvantages:
  1) psychological -- you "think" you have more money than you do because you see a large untaxed amount.  Having $100k in your 401k is different from having $100k in the bank since you still need to pay taxes on the 401k money.
  2) unknown -- when you have money in a 401k, you know you'll have to pax tax but you don't know what the future tax rate will be.  Will it be 5%?  20%?  50%?  That will make a difference and the Roth removes this worry.

That said, I don't believe paying the tax up front in a Roth necessarily saves you anything.  It will depend on your tax rate now and in the future.  Some people say you'll be in a lower tax bracket in retirement so a Roth is bad because you can either pay a higher rate now or a lower rate later.  Others are worried about rising tax rates so you either pay taxes now while rates or low or pay taxes in retirement when rates might be higher.

Since we don't know the rates, let's use some simple numbers.  $1000 investment*, 5% rate of return, 30 years to retirement, and 20% tax bracket.

The * for $1000 investment is because it's not fair to start with $1000 investment in both cases.  Let's say you put $1000 in the 401k so you had to earn exactly $1000.  You can't put the same $1000 into a Roth since you'd have to earn more to have $1000 left after tax.  $1000 into a Roth with a 20% tax means you'd actually have to earn $1250 where $250 goes to tax and $1000 goes to Roth.  For the Roth, if you earn $1000 and pay 20% tax, you only have $800 left to invest.  So, starting points:

Roth:
$200 paid in tax up front
$800 invested
  After 30 years:  800 * 1.05^30 = $3457.55
  Tax owed:  $0
  Actually available:  $3457.55

Tax deferred IRA:
$0 paid in tax up front
$1000 invested
  After 30 years:  1000 * 1.05^30 = $4321.94
  Tax owed:  20% * $4321.94 = $864.39
  Actually available:  $3457.55

You could say you paid less in taxes with the Roth since you only paid $200.  In the tax deferred case you owe $864.39.  Note that this is explained by the $200 you gave up to taxes right away in the Roth that wasn't able to grow:
  $200 * 1.05^30 = $864.39

So, unless somebody wants to point out a flaw, I don't necessarily see that there are any tax advantages in the Roth.  But, even though I think the retirement values after tax are essentially a wash, I still think the Roth is better because of other advantages, because you remove the unknown of future tax rate, and because what you see in your account is really what you have (not a larger value that hasn't yet been taxed).

[tigger]

And, finally, are there any ways to convert to a Roth in an employer plan while still employed with that employer?  Any loopholes?

For example:  It would be nice to consolidate into a Roth, remove the unknown future tax rate, and to have money in an account that's not as restrictive as the employer plan.

[Eddie]

Well it looks as though some people still have a glimmer of hope out there that things will resume to normal in thirty years. What type of stocks do you suggest to invest in, blue chip, foreign, gold ?

Should we max out our contributions too?

I would bet that any young person starting a Roth would be highly disappointed when it comes time to withdraw funds. I think the game is rigged and its just another ponzi scheme ready for set up.

[Atash Hagmahani]

Eddie, you can put all sorts of interesting things in a retirement account, including gold buillon and farmland. Does that sound too optimistic?

 

The trick is to know how to do it. I'll write more later. I have a surprised birthday party to get ready for.

[Mike]

I would bet that any young person starting a Roth would be highly disappointed when it comes time to withdraw funds. I think the game is rigged and its just another ponzi scheme ready for set up.

Remember Obama's "We want your money" speech that Stump Rancher posted?

Remember the talk of legislatively reforming mortgages?

Remember the cap on executive pay proposal?

Remember Obamacare & the death councilors?

Remember that the various bailouts have been paid for with short term debt that will have to be refinanced?  soon.  And then again and again?

Opt out!

The best retirement plan is investing in the next generation, now.  Pay attention to the next generation with time, money, and infinite tolerance.

Travel to other countries with the question, "Could this be a retirement refuge?"  And remember, we might have to go there sooner than we think.

[Eddie]

Eddie, you can put all sorts of interesting things in a retirement account, including gold buillon and farmland. Does that sound too optimistic?

Sounds great...Is it better and possible to go the Roth way for these?

Im looking forward to what you have to say.

The best retirement plan is investing in the next generation, now.  Pay attention to the next generation with time, money, and infinite tolerance.

You first Mike. The next generation is being programmed slowly to go with the flow. People like us will be considered an enemy of the state.

Mr Murphy ain't timid...you can call me Mr Murphy if you want to. 

[Mike]

The next generation is being programmed slowly to go with the flow. People like us will be considered an enemy of the state.

The best retirement plan is investing in the next generation, now.  Pay attention to the next generation with time, money, and infinite tolerance.

[emphasis added]

The idea isn't to change the entire next generation, just the few that we can expect to take care of our retirement.  In the best case scenario that would be our biological kids.  Otherwise it might be near relatives or our immediate community.

Even if a Roth multiplies, in old age one needs a younger person with sound judgment to look after ones interests.  A social worker probably won't work.

[Eddie]

In the best case scenario that would be our biological kids.  Otherwise it might be near relatives or our immediate community.

Well that's a little different then, and reasonably sound advice at this point in the game IMO.

I will invest in a David Lee Roth show if he comes to town again but not in a David Lee Roth IRA ever again.   

[Atash Hagmahani]

Yes, Mike, we're laying the foundations now. One thing we need to do is create our own culture and our own school system, to keep the young people from being programmed NOT to take responsibility for their own elderly. Neotrotskyism states that "workers" who take responsibility for taking care of their elderly parents, will be reluctant to take whatever jobs are assigned to them, where-ever they are assigned (ie, loss of mobility), and that, furthermore, extended families are extremely taboo for a variety of other reasons, including "granny daycare" (ie, all transactions must be public and commercial).

I covered that issue in one of my "Homeworld" series episodes. That reminds me; I have another episode to publish imminently.

Eddie, I have just sprung for a service that writes up the legal paperwork to create an LLC to use as a wrapper for a Roth IRA, the custodian of which will let me invest in any investment that is NOT prohibited by the tax code.

This is a "self-directed IRA".

It not only reduces my overall risk, it also frees up funds for purposes that are useful to further my present state of existence.

You could, for instance, fund your own business that way. There are restrictions, but the doors that are opened are considerable.

The purpose of this is to open up investment classes OTHER THAN those controlled by Wall Street, which increasingly I am convinced is a den of thieves.

[offdalip]

Roth:
$200 paid in tax up front
$800 invested
  After 30 years:  800 * 1.05^30 = $3457.55
  Tax owed:  $0
  Actually available:  $3457.55

Tax deferred IRA:
$0 paid in tax up front
$1000 invested
  After 30 years:  1000 * 1.05^30 = $4321.94
  Tax owed:  20% * $4321.94 = $864.39
  Actually available:  $3457.55

You are only looking at the nominal gains........


In terms of actual buying power, if the rate of inflation is 5% then your actual buying power stays exactly the same. No gain. If the rate of inflation is over 5% then you end up with less than you started.

BLS just reported that the rate of inflation for all of 2009 was 2.9%.
Do you believe that? And suppossedly we are in a deflationary environment.......

[offdalip]

The purpose of this is to open up investment classes OTHER THAN those controlled by Wall Street, which increasingly I am convinced is a den of thieves.

when we had a growth environment and some stabilty (1980-2000) you could at least make some money with the thieves. Nowadays, it is outright chicanery in the open, highway robbery, bandidos . do not trust what hey tell you. buy and hold is stupidly irresponsible for instance/ You have to actively manage any investment yourself