Many individuals are wondering whether to take advantage of the recent change in the law, now making Roth and Roth conversions available to individuals with AGI over $100,000.
The choice of whether to contribute to a regular deferred retirement account, or Roth or to do a Roth Conversion depends on the following factors:
1. Relative tax rates now vs. tax rates in retirement.
If your tax rate in retirement will be the same as your tax rate while working, and you expect to draw monies at the same time, and the accounts earn the same rate of return, then you should be INDIFFERENT to the choice, as there will be no difference.
This example illustrates the above: Mr. Smith can contribute $5,000 a year pre tax to a tax deferred retirement account, or if he chooses to a Roth account, and he is in the 25% tax bracket. If we assume a 7% return, and using the rule of 72, the account will have a value of $10,000 in about 10 years. If he withdraws the entire amount, and he is still in the 25% tax bracket, he will net $7,500. The Roth contribution is after tax money, so he would be contributing $3,750 ($5000@ 25% tax). Assuming same rate of return, after 10 years, the account value would be the same $7,500.
2. What about all the hype and the assumptions that your tax rate in retirement will be higher? In my opinion, it is problematic, because it confuses marginal rates with effective rates. Assuming a portfolio value of $4 million and an RMD devisor @ age 70 of 27.4 yields a distribution of $146,000. Based on current law, except for inflation indexing, for a married couple filing jointly, this would provide an effective rate of about 19%, not 28%. The first $16,000 will be taxed at 10%, the next $51,000 at 15%, the next $70,000 at 25%, and the last $9,000 at 28%.
3. In my opinion, most individuals will not be in the 28% tax bracket in retirement, unless their ending portfolio was significantly higher than $4 million. Most affluent wage earners, who are not truly wealthy, can reasonably project effective rates at retirement lower than their current marginal rates.
4. What about the possibility of higher taxes in the future? Even if we assume the Bush tax cuts die, and rates for the highest taxpayers go up 3-4%, this still does not change the above analysis. As long as the 10% and 15% brackets remain, my analysis does not change, and future effective rates for most affluent taxpayers will be lower than their current marginal rates. For the record, it should be noted that no president has seen fit to alter the 15% tax Bracket since it was introduced in 1986.
5. When does a Roth or a Roth Conversion make sense?
For taxpayers in the highest bracket today, 35%, and income of $500,000 -$1,000,000 a year, a Roth may make sense. A conversion may make sense if you have a very large retirement account, can pay the tax due from other sources, do not need RMD income to live on after age 70 and are interested in a wealth legacy for future generations.
6. The following example illustrates the wealth legacy transfer available through a Roth:
Due to the fact that Roth’s do not require RMD’s and the 8th wonder of the world, compound interest, this effect can be huge. Mr. Smith, age 55, has a $1,000,000 IRA and substantial other assets, which he could use to pay the conversion tax, and he does not need the RMD’s for living expenses. Assuming a 50/50 asset allocation and an average rate of return of 6%, and the Rule of 72, he can reasonably expect 2-3 doubles of the account. If he lives to age 79, there will be 2 doublings, or an account value of $4,000,000, which could be passed to his heirs, income tax free. If he lives to 91, which is not improbable these days, there would be 3 doubles, or an account value of about $8,000,000 to pass on to future generations.
7. Aside from building a wealth legacy, paying the tax now on conversion only makes sense if you think your future effective rate is likely to be higher than your current marginal rate applied to the conversion.
8. It should be noted, that none of the above takes into consideration the possibility of a future change in the law, legislation that takes away the Roth 100% income tax free benefit.
9. Conclusion: In my opinion, except for taxpayers far into the highest bracket, 35%, and those primarily interested in leaving a Wealth Legacy, Roth and Roth Conversions do not make economic sense.