by Gregory Kolojeski
The following copyrighted article is available exclusively on the Roth IRA Web Site:
A Roth IRA conversion is not favorable until you have held the assets for a period of X
years (setting X equal to 5, 8, 10, 15 or any other arbitrary number).
There are so many variables that affect the desirability of a Roth IRA conversion that
there is no way one can make a general statement about how fast a conversion becomes the
better alternative to not converting. In many cases, one is better off immediately upon
converting. In some cases, converting never becomes the better alternative. The only way
one could make a sensible general statement about some time period would be to specify the
numerous assumptions that one is making (such as growth rates, ages of the owners,
withdrawals, etc.).
You should never convert to a Roth IRA if you have to use IRA assets to pay the income
taxes.
Are you better off economically if you pay the taxes from other assets? Absolutely.
Does that mean that a Roth conversion where you pay the taxes from the IRA is never better
than not converting? Absolutely Not. The desirability of paying the income taxes
from other assets is only one economic factor that makes a Roth conversion work. If you
are taking advantage of one or more other features (post-70½ tax-free compounding,
tax-free compounding in the hands of the beneficiary), you can still come out far ahead
with a Roth Conversion even when the income taxes on the conversion are paid from the IRA.
You should not convert to a Roth IRA if your retirement income tax rate is likely to be
lower than your pre-retirement income tax rate (or the rate at the time you make
contributions or convert).
This is probably the biggest myth promulgated by those that should know better. The
main desirability of IRAs and Roth IRAs is due to tax-advantaged compounding. When the
compounding is tax-free as in a Roth IRA, the IRA balance will increase much faster than
had the compounding been only tax-deferred. With a Roth IRA, one will often have a much
larger balance even if one's post-retirement income tax rate is significantly lower
than earlier rates. If you can take some advantage of the extra compounding a Roth IRA
offers (post-70½ tax-free compounding, tax-free compounding in the hands of the
beneficiary, grossing up the IRA balance by paying conversion income taxes from other
assets), your expectations as to future growth will be much more important than expected
income tax rates.
Income tax considerations are the most important factors in evaluating a Roth IRA
versus a Traditional IRA.
See the prior question. The effects of tax-free compounding and future growth are
generally much more important.
Compounding examples prove that Traditional IRAs and Roth IRAs are equivalent.
This is only true when the example given is simplistic enough to treat Traditional and
Roth IRAs as if they are identical in all respects except for how they are taxed. A Roth
IRA becomes a Traditional IRA if you take distributions from the Roth IRA when not
required, if you do not show required minimum distributions for the Traditional IRA, if
you do not pay conversion taxes from other assets, and if you show no advantage to the
beneficiary. Then, there is no difference. Admittedly, these Roth IRA attributes are
complicated things. But they are there and you can't ignore them. At least not if you want
an accurate picture.
The four-year spreadout of taxable income that is available for 1998 conversions should
be a major factor in determining whether to do a conversion.
Although the four-year spreadout is a nice benefit, the economic advantage of this
feature is relatively small. It's unlikely this benefit itself will tip the scale towards
doing a conversion. From an economic viewpoint, at least three other features of a Roth
IRA are much more important (post-70½ tax-free compounding, tax-free compounding in the
hands of the beneficiary, and paying the income taxes on conversion from other assets). If
a conversion makes sense in 1998, it will likely make just as much sense in 1999 or later
given otherwise similar circumstances.
It is always better to pay income taxes later than to pay them now.
The name of the game is how many assets you have after taxes. If paying taxes now will
likely give you significantly more net assets later, why shouldn't you? Uncle Sam is going
to get his share either way. When it comes to IRAs, you will always pay some income taxes;
it's just a question of timing. Pay something now or pay more later. It's your choice.
A flat income tax will make a Roth IRA conversion a bad idea.
Tax-free income is tax-free income. This is true whether your future rate is
17%, 25% or 40%. Tax-free compounding is very powerful. We've run scenarios with drastic
reductions in tax rates in just a few years and Roth IRAs still come out ahead much of the
time. Query: What if income tax rates go up in the future? Roth IRAs will look even
better.
Since Roth IRAs work so well for younger people, a Roth IRA conversion for an older
person is not a good idea.
A young person can take advantage of many decades of tax-free compounding in a Roth
IRA. But that does not mean that a Roth IRA is any less desirable for an older person. If
an older person sticks with a traditional IRA, the required minimum distributions will
quickly whittle away at the tax-advantaged compounding. With a Roth IRA, you can continue
tax-free compounding for as long as you or your spouse are living and continue to keep
funds in the Roth IRA (and your beneficiary who then takes distributions over his life
expectancy can also take advantage of tax-free compounding instead of tax-deferred
compounding.) For similar reasons, a deathbed conversion to a Roth IRA can make a lot of
sense. Suddenly, your kids now have an income tax-free asset.
Roth IRAs make more sense for persons with smaller IRA balances.
Just the opposite. IRA owners with larger balances are more likely to be able
to take advantage of the tax-free compounding than those with limited assets. In addition,
the Roth IRA has many estate planning advantages (meaning that the kids can get more if
you want them to). By estate planning advantages, we mean that the tax-free compounding
offered by a Roth IRA can result in greatly increased IRA balances on an after-tax basis
when contrasted with a Traditional IRA. This is primarily due to the income-tax free
aspect of a Roth IRA, not estate tax considerations. Even if the federal estate tax were
to be abolished tomorrow, Roth IRAs would still have these estate planning advantages.
(Both Traditional IRAs and Roth IRAs will generate a federal estate tax if one's estate is
large enough.)
Roth IRAs are too good to be true.
Tax-free compounding. Tax-free compounding. What else need be said?
For a related article, see Five Financial Features that Make Conversion to a Roth IRA So Desirable at www.rothira.com/five.htm.
For the latest information on Roth IRAs, see the Roth IRA Web Site at www.rothira.com.
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