Monday, February 15, 2010

Traditional Roth

There has been big financial news this year. I do not mean the big bonuses that Wall Street is handing out to its undeserved staff. (Really, how many traders beat the stock market index consistently? And so you are rewarding luck? Or bankers that brought in money to be funneled into complex debt obligations? If they understood the problem with CDOs, shame on them. If they did not do their homework to learn about CDOs, shame on them.) I am talking about the removal of the income limit for conversion to a Roth IRA.

It seems simple enough. Financial advisers are all busy counseling clients about whether or not they should convert an IRA to a Roth IRA. Unfortunately, that distracts everyone from actually learning about IRAs, as I am sure most people have forgotten how they decided on their current retirement strategy. Now I am no tax expert, and I am by no means trying to tell anyone how to manage money. I just think people should understand why this news is important and also why it is somewhat ludicrous.

To start, all money that you save will be taxed at least once. That’s right. If you play your cards incorrectly, you could actually pay taxes twice on your nest egg. But that is a rare bird. Forget I even mentioned it. The difference between some IRAs is when you pay those taxes. You can pay them up front by using posttax money to fund the IRA. Then you would not pay taxes when you withdraw the money later. Or you use pretax money to fund the IRA and pay taxes later at the time of withdrawal. Seems simple, right? Wrong. There are several other factors that complicate things. First, your tax bracket may change. If you earn a lot of money now, you are in a higher tax bracket. Let us say your bracket is 33% for simplicity’s sake. That means that if you are funding your IRA with posttax money you have to earn $150 to put $100 posttax into the IRA. Now let us say that IRA grows to $1000 over 30 years at 8% and you withdraw it. You have already paid taxes on that money, so you get all $1000. But what if you used pretax money? You would then invest $150 to start. Over 30 years at 8% you would have about $1650. But you do not get all that because now you have to pay taxes. At a 33% tax bracket you are left with $1100. Certainly seems that a pretax or deductible method would be preferable, right? Let us look a two other scenarios.

If your tax bracket goes down over time because you retire and earn less wages, say from 33% to 25%, what happens to the numbers? If you still invest $100 in the posttax scenario, you would have $1000 after 30 years. In the pretax scenario, you would still invest $150 (since you start in the 33% tax bracket) and end up with $1650 pretax. But because you are now in the 25% tax bracket at the time of withdrawal, you get $1238. Certainly building the case for using a pretax money or deductible money to fund the IRA. If your tax bracket goes up over time, say from 33% to 40%, you would still have $1000 in the posttax method after 30 years. In the pretax method you would still invest $150 and end up with $1650 pretax. But after 40% taxes at the time of withdrawal you would be left with $990. Not a good case for using pretax money to fund your IRA.

To sum up, if your tax bracket stays the same, the pay taxes later works out. If your tax bracket goes down the pay taxes later works out. If your tax bracket goes up the pay taxes now works better. So for most people, since most people will go down a tax bracket or two over their lifetime, it makes sense to fund a pretax IRA. These are for the most part traditional IRAs. That would mean posttax IRAs are Roth IRAs, and for most people that is true. If you take this separation in this simplistic sense, there is a catch that makes the posttax IRA or Roth IRA preferable, and that is the contribution limit. IRAs have a yearly contribution limit, most recently set at $5000. What that means is that if you contribute the maximum $5000 to a posttax Roth IRA, it is equivalent to $6944 invested in a pretax traditional IRA if you are in a 28% tax bracket. The catch is that you cannot invest $6944 pretax. You can only invest $5000 pretax, which is the equivalent of $3600 posttax. Thus, it is to your advantage to use a posttax Roth IRA method if you intend to contribute the maximum each year. This is why the general rule of thumb is to fund a Roth IRA if you can.

Then there is the circumstance that needs explanation, since the explanation is not easily found on the internet. There are income restrictions on who can open a Roth IRA. If you make too much money you cannot fund a Roth IRA. However, anyone can convert another IRA into a Roth IRA. This is what the new rule states. Effectively, this then means that someone who makes too much money to fund a Roth IRA could simply fund a traditional IRA and convert it every year to a Roth IRA. They would simply have to pay taxes on the converted amount. Makes you wonder why the government did not just remove the income limit for contributing to a Roth IRA. Well they did not, so some will have to take the convoluted path to a Roth IRA.

The other circumstance that is worth mentioning is when a traditional IRA becomes posttax. Typically you get to deduct your contributions to a traditional IRA. However, once your income passes a certain limit and you participate in an employer retirement plan (401k, 403b, or the like), your contributions to a traditional IRA become nondeductible, meaning that all contributions are posttax dollars. In this circumstance, you will also have to pay taxes on withdrawals when retirement comes. You pay taxes now and your pay taxes later. You do not pay double tax because you can track the tax basis of your contributions over the years and at least get credit for the taxes you have paid. But compared to a Roth IRA, where the growth of your money remains untaxed at the time of withdrawal, why would even bother with a traditional IRA? And the catch to that is that if you convert a large traditional IRA now you have to pay the taxes on it now. 2010 is special in that you can spread the taxes over 2010 and 2011, but still, if you convert a $100,000 traditional IRA to a Roth IRA, and you are in a 28% tax bracket, you need to have $28,000 on hand to pay the taxes. Most people would not have that money lying around.

So that is the short story on the big Roth IRA conversion news. There are certainly many other nuances to the IRA story, and I think I have only covered the most common scenarios. I for one will be moving my money to a traditional Roth IRA. Because this stuff is not confusing at all.