Roth Conversions: Any Good Reason?

[BobKamman]

A relative asked me about Roth conversions. I can never think of any good reasons to do one, and I especially don’t understand why investment advisers suggest them: Doesn’t it give them less money to play with and therefore, less commission income? I will admit that if someone is moving from Nevada to California, or Florida to New York, it might be a good idea to avoid state taxes. But most of the traffic goes in the other direction.

It seems like a simple formula to me: If you have $1,000 and want to pay $200 tax on it now, you have $800 left to invest. Let’s say you can earn 10% for the next five years. You end up with about $1,289 tax-free. Or, you can keep your $1,000 and invest it at 10% for five years. You’ll have about $1,611 and, after paying tax on it at 20%, you’re left with about $1,289.

So it might be a good idea if you expect your tax bracket to increase, but that involves predicting what Congress is going to do with tax rates every year or so. And I have seen clients withdraw thousands from their IRAs, tax-free, to pay assisted-living and other medical expenses in their final years. The best bracket is zero percent, even if you arrive there with unfortunate deductions.

Back before the last recession, I saw a client pay about $30,000 in tax to convert $100,000 to a Roth – he invested it in tech stocks, which quickly lost more than half their value.

Am I missing something here?

[rbynaker]

I think they make much more sense for lower income folks.  If your income is below the standard deduction, do a partial Roth conversion and still pay $0 tax (although at that point I'd probably use the 10% bracket too).  If the balance in the client's IRA is large enough that RMDs are going to make SS taxable, you can do Roth conversions in their 50s & 60s to get the income out of a taxable IRA and keep the SS income taxed at 0%.

But you're absolutely right, mathematically you're just playing "guess the tax rate."

I've read articles about the psychological aspects (not sure how much I buy into them).  In your example the taxes were paid out of the Roth at conversion ($1,000 becomes $800), but this also becomes an opportunity to "invest" the other $200 from outside funds so it becomes a forced savings (I guess psychologically most folks instead of saving the money would just spend it on hookers and blow?)  And on top of that, the forced savings grows with 0% tax in the Roth.  At least until Congress decides they want to start taxing Roth earnings. 🙂

[sjrcpa]

Also, no RMD with a ROTH.

[qbteachmt]

You are missing the time value of the increase (hopefully) over remaining time. A 5 year analysis is only the start. If you are close to RMD age, then you have a different analysis than someone who is 30 or 40 or 60.

If you intend to leave the funds to someone, they avoid RMD with the conversions.

Also, available funds to pay the taxes would be helpful. I have been doing this for about 5 years, and have 7 more years I intend to convert. Then, there still should be another 7 years or so before I might need to use those funds. This is a great time to convert if you have Basis in the traditional, as well.

Let's review:

If you listen to Dave Ramsey, he clearly explains how the Roth growth as tax free (at least for now) beats tax deferred growth starting when you are young, setting aside matching considerations for 401(k)/Traditional. It's another "rock, paper, scissors" formula:

Match beats Roth beats regular investments

That means younger people should be putting into Roth whenever possible instead of going for deferral, but leveraging for match first. Once you find yourself forced by "best option" into a deferred account, your next step is to make conversions as quickly as you can afford to, so that the growth is then tax free. Basis (backdoor) Traditional should always be converted right away, of course. One thing Dave Ramsey overlooks is if the person is doing a backdoor Roth and also has Basis from other activities.

Under typical projected scenarios, you will double your funds every 7-10 years, depending on the variables, of course.

Example: You start with $1,000 in Traditional IRA. You convert and pay for that tax with regular funds, so that the full $1,000 still gets invested through the Roth. Given that projection of 7 years = $2,000, you only paid the taxes in your example of $200 and if you are in your 30s or 40s, then by the time you get to 72 (thank you, Congress), you paid $200 and you end up with around $16,000. And now none of that is taxable or has to be withdrawn at all.  And it won't count against income for IRMAA, if you do start using it.

You wouldn't pay the taxes from the distribution/conversion unless you are over 59 1/2. It's better to pay from cash on hand. You sure don't want to incur the 10% early withdrawal penalty. And that means not expecting to also pull funds from the deferred account in the next few years, because otherwise, why convert? There isn't a lot of headspace for growth, that late in the game.

As for fees, it really depends. We work self-directed for all accounts. If you use a fee broker, you likely use them for any account type, so there is no difference to their fee.

Roth 401(k) has RMD. That's why you would transfer this to Roth.

[BobKamman]

@rbynaker 

Yes, it could work for someone whose AGI is below the filing limit.  I have several clients whom I advise to take withdrawals from their IRA, even if not required, so there is less to be taxed later.  It's usually a relatively small amount -- four digits, not five or six -- and their lifestyle is not extravagant.  I often point out that they saved the money for their old age, and now they are old, and they should spend some on themselves. 

As for the shell game of taking the $200 from one pocket to protect $1,000 in the other pocket:  Can't the same be accomplished with a non-qualified annuity?  There are some good products out there, typically not those marketed by banks and commissioned agents, that at least keep the cash out of the hands of government.  Yes, the income might be taxed eventually, but how much would it have to earn, for the tax in 20 years to be more than the tax avoided now?  In normal times, tax-free bonds might be an alternative, also.  

[BobKamman]

@qbteachmt 

A 5 year analysis is only the start. If you are close to RMD age, then you have a different analysis than someone who is 30 or 40 or 60.

No, you can carry it out 10 or 20 or 30 years and the math works the same.  Or maybe you're saying that if I am at RMD age, I should take into account having to pay tax on $50 or $60 of my $1,000 every year.  Where is the breakeven point, age 90?

If you listen to Dave Ramsey, he clearly explains. . .

You can actually listen to Dave Ramsey? I won’t hold his 1988 bankruptcy against him, but he’ll clearly explain why anyone should patronize the advertisers who pay him for endorsements.

As for fees, it really depends. We work self-directed for all accounts. If you use a fee broker, you likely use them for any account type, so there is no difference to their fee.

The fee is not a percentage of the account value? The millionaire pays the same as the college kid who inherited $10,000? Socialism, I tell you. Socialism.

[qbteachmt]

"you can carry it out 10 or 20 or 30 years and the math works the same."

If, for every conversion, you pay the taxes from the distribution, and if you also incur an early withdrawal penalty for using the funds to pay taxes, you would be falling behind and you need a new advisor.

Think about the cycle of events, for two scenarios. Give them both the same age and amount in Traditional IRA, same investment mix and income tax bracket. One converts a fraction (say, 15%) every year between, oh, 40 and 55 and pays taxes from available funds. The other does no conversions. Now project out 20 more years, for growth. Who is better off at 75? Because the time value means the majority of any fund is (hopefully) growth/income, not your own contributed funds. That's why a younger person would want to put into Roth early and why, if you can afford the tax on conversions with outside funds, there is only upside to conversions as early as possible.

Obviously, all of this is simplistic math, not actual computations to meet someone's specific needs.

You would not bother to convert and pay taxes when you are near or at the stage of taking RMD and going to be reporting that for income tax anyway; unless you can afford that tax hit because of having both activities (conversion and RMD) and you still want to shelter some of the funds by moving them to a Roth.

For instance, doing conversions at 70 might make sense for one person and not another, depending on their overall financial picture, life expectancy, types of investments, needs in their old age. My father-in-law lived to 94; did we anticipate that? Yes, actually. It runs in the family.

Dave Ramsey holds his bankruptcy against himself. I don't see how that is an issue. As for advertising, how is that different than getting content any time you watch television, listen to podcasts, radio, audio books, other programming and even most printed materials, because, although I skip forward on lots of video, all that branding is everywhere. Look at the amount of product placement in video productions; every time you see a logo, an Apple iphone, a Ford truck or police car, etc, that got paid for. It doesn't result in you patronizing all of the advertisers on those shows, I assume. Heck, we still don't even have a Panera, although we got promise one a few years ago.

"The fee is not a percentage of the account value?"

Fee agreements vary and are not required. That's what "self-directed" means = no broker manager, no management fee. Besides, your example investor still has the funds in Roth, converted from Traditional. That doesn't shelter the Roth from fees, if there is a fee agreement in place. Oh, your comment is directed towards the person who didn't make a full conversion and paid the taxes out of the conversion as a distribution? Again, that's not the best strategy for conversions.

Investment planning and management includes a lot of opinions, many of which you can get from sales people, of course. Annuities, whole life, bonds, and other strategies will certainly make some investors feel more confident, and makes the other people more commissions.

[BobKamman]

"Time value of money" argument is nonsense, but works on people who are mathematically challenged.  It helps explain why people are doing this for no good reason.  It also assumes that no tax laws will be changed.  When they came for inherited IRA's, I said nothing, because I didn't have an inherited IRA; when they came for Roth IRA's, the taxpayers with inherited IRA's just shrugged.

Advertising requires listeners, which requires content, even when there is no good advice to be given.  There are a lot of snake-oil salesmen touting a particular political philosophy, when they know little either about social developments or the nutritional supplements they promote.  Then there are those who are gold bugs.  I worked in radio for a few years, and learned about brokered time -- on weekends, even on major stations, you can buy half an hour and produce your own "show" that promotes your own financial advice, or health cures, or travel planning.  The less educated eat this stuff up because they don't realize it's just a commercial.  If it's on the radio, it must be true -- just like now, with the Internet.  

Hard to believe it has been 10 years since Bruce Williams retired.  He paved the way for Ramsey, but without the preachy, you-kids-get-off-my-lawn style.  They are both good entertainers, but shouldn't be taken seriously for one-size-fits-all advice.  

[qbteachmt]

It's not clear why you asked about this, since you have taken a pretty firm position. And I made one comment about Ramsey; I don't see how that deserved your responses. I doubt any of the "all stars" peers on this forum are math challenged, but thank you for the observation as to our skills. Nothing exists in a vacuum; I used to enjoy watching Suze Orman's Saturday night show, too, especially the one with the lady on the "Can I afford it?" segment, she called in twice even, to go to Elf school in Iceland. As for brokered time, you don't even need advertisers; local cable access channels need programs to fill their slots. It seems you might have something to contribute there.