ROTH conversion strategy (7% less taxes in Nevada)

[Guest gw55]

Hi,

I would appreciate any comments on a question on IRA/ROTH strategy.

I have about 900K in my traditional IRA.

And, for the past two years, I have been making ROTH conversions.

Today, I redid some calculations, and ROTHs seem much less desireable

than before due to the 15% cap gain and 15% qualified dividend fed taxes.

And, there is a chance that when I retire I would move from Calif to

Nevada (a no income tax state). Assuming the rates stay the same, that would

reduce my effective overall tax rate from:

.25 - .25 x .093 + .093 = .32

to:

.25

That is a 7% decrease in overall taxes!

As a result, I am considering no more ROTH conversions, which would save

me some money now that would otherwise be used for taxes on ROTH

conversions.

If I knew for certain that I would be moving, it would make sense to

keep the traditional IRA intact (no conversion), right?

I probably will not need the money for 20 years or so.

But the calculations I have done indicate that the 7% tax penalty

is more than the ROTH conversion benefit.

regards,

gordon

[Bruce Steiner]

It's hard to tell without seeing your calculations. But it seems surprising that a 7 point difference in the tax rates would outweigh the benefits of the Roth conversion. What assumptions are you making as to the rate of return in your IRA, the rate of return after income taxes on your taxable account, your estate tax rate, how long you will live, the age of your beneficiary at your death, etc.?

[John G]

If all you are looking at is convert now versus convert later and there is a tax gap of 7% from one location to another, then your conclusion is correct.

Some "buts" to think about:

Nevada may change their taxation policy.

You may not move.

US government may change conversion rules. (+ or -)

You may not be eligible in the future to convert because of your income.

Rates of return have no impact on the decision unless they differ between taxable and tax sheltered accounts or unless the rate of return increases your assets and bumps you to higher tax brackets.

You are correct that the current lower tax rates of long term capital gains and some dividends cuts into the advantage of IRAs. However, they have no impact between Roths and IRAs, just between tax shelters and tax able brokerage accounts. I am not so sure you should assume that the favorable LTCG and dividend rates will continue. Also note, not all dividends get this favorable treatment. REITS do not. I think some foreign company dividends are also excluded. There is also a complicated 60 day holding period so dividends from recent stock purchases don't count.

Often, a hybrid strategy that combines IRA, Roth and taxable brokerage is a solid way to proceed. This gives you some control over distributions. You then have three different places to put your investment choices.

I suspect that there are non-taxation issues that may also be important drivers. If you post again, you might want to add info about your age, current income, career/retirement plans, marital status, etc.

[Guest gw55]

John,

All good points. Except that I think the rates of return have an

impact. The ROTH conversion gets its boost (over the IRA) because of the

growth rate. For example, if the growth rate is zero, and the tax

rate remains the same, they both have equal value at withdrawal.

So, a very high growth rate gives the conversion more benefit, right?

But, I am persuaded that ROTH conversion beats IRA most of

the time. So, my current IRA/ROTH strategy is something like this:

At age 70, plan to have

200K-300K in IRA

The 200K min allows you to add to your AGI if your income in later years is

below the top of the 15% bracket (29K + deductions + exemptions).

The 300K max is to reduce the RMD demands, and to increase the

likelihood that you will reduce the IRA to zero in your lifetime.

ROTH

Convert IRA money into ROTH to reach IRA target at 70 years old.

Taxable

Best place for long term stocks, stocks with qualified dividends.

Allow tax deferred accounts to grow, and take money out of here first.

I am retired, trying to optimize ROTH and IRA allocation at present.

regards,

gordon

[ElGuapo]

John,

All good points. Except that I think the rates of return have an impact. The ROTH conversion gets its boost (over the IRA) because of the growth rate. For example, if the growth rate is zero, and the tax rate remains the same, they both have equal value at withdrawal.

So, a very high growth rate gives the conversion more benefit, right?

I'll let John respond as to exactly what he meant, but he's basically right, the growth rate really doesn't come into the equation. Whatever the growth turns out to be, whether it doubles, triples, whatever, paying taxes before or later is the same (all else being equal). It's a fundamental property of multiplication which I probably knew the name of at some point.

That is, take 1 x 0.75 (paying tax before) and you get 0.75 to invest. If it doubles you have 1.50 which you take out tax free (Roth).

Take 1 (pay no tax until withdrawal), let it double to 2, then x 0.75 at withdrawal (traditional IRA), you're left with 1.50.

[Guest gw55]

Ty07480,

Your example assumes the taxes are paid from the IRA account.

This is usually (maybe always?) a bad choice.

The taxes should be paid from non retirement money.

regards,

gordon

ty07480 said:

>That is, take 1 x 0.75 (paying tax before) and you get 0.75 to invest. If it doubles

>you have 1.50 which you take out tax free (Roth).

>Take 1 (pay no tax until withdrawal), let it double to 2, then x 0.75 at withdrawal

>(traditional IRA), you're left with 1.50.

[ElGuapo]

Ty07480,

Your example assumes the taxes are paid from the IRA account.

I don't think any such assumption exists in making this statement. Take a look at this previous thread where I offered (hopefully) a clearer explanation of the same topic.

Anyway, the point is a good one that taxes should be paid from nonretirement money.

[John G]

1. Taxes should be paid out of non-IRA funds. I don't think even twisted examples are exceptions.

2. For almost all people, the common assumption is that rates of return inside the IRA and for taxable funds are the same. With rare exceptions, the rate or return will not change the evaluation for Roth conversions. An extremely rare exception is when a taxpayer has opportunities for very high rates of return on only part of his assets. In this case, the Roth can benefit very much from the selective investments. {I am not talking about just "hoping" that your Roth investments will perform better, but in that rare instance when you know that a small part of your investments will perform way above average. I can't say anything further about this, but I know a few people who have these circumstances.}

3. Roth conversion is not a slam dunk better for all folks. In many instances it is very close to a draw because the best assumption is same taxation now and in the future and the same rate of return inside and outside the Roth. Where Roth conversions work best are when: (1) unemployment or other circumstance drops taxable income in one year, (2) early in your career when you expect to have higher incomes, (3) to gain some flexibility on mandatory distributions, (4) related to estate planning and (5) to convert before you no longer qualify due to income. DO NOT assume that a conversion is advantageous for you and get a professional (accountant, financial planner or tax advisor) to review your circumstance. There are a lot of assumptions in modeling a Roth conversion. It seems that if people want to convert, they tend to use positively biased assumptions. Get a second opinion.

[mbozek]

The primary advantage of a Roth IRA is that distributions can be deferred after 70 1/2 until the later of the death of the owner or spouse which is beneficial for persons who have other assets for retirement. However converting to a Roth IRA has an opportunity cost in the loss of investment income for the amounts used to pay taxes on the conversion. The investment value of $10,000 in after tax income used to pay taxes at a 6% after tax return for 20 years would be worth 32,071. This amount will reduce the non taxable gains from the roth IRA.

[John G]

Mbozek, you are spot on with your comment about the opportunity cost related to what would be the growth of assets that are used to pay taxes. If you have taken an economics class, you might remember "opportunity cost". Even if you are trained in financial modeling, you still might make mistakes with the analysis of a Roth IRA conversion, much less on chosing the assumptions.

Modeling a Roth conversion is not simple matter. You have lots of assumptions to make future: taxes, Roth/IRA rules, state of residence, life expectancy, investment earnings are just a few of the major ones. Our ability to predict future events is very limited. I was trained as a planner - and I know how hard it is to get it right even looking out just a few years.

A little exercise for every reader. How good are your predictions about the future? Before you answer, do this exercise.......

Go back 10 years and think about what changes happened in your life during that time you never predicted. Can't think of any? How about the Roth IRA itself... didn't exist 10 years ago. Did you move? Did you change jobs? An inheritance? A promotion? Children born or adopted? A health change? A marriage? A divorce?

Now go back 20 years and do the same exercise.

When I first started looking at Roth conversions in 1998, I too thought it was a slam dunk in favor of Roths. I now recognize that very often it slightly favors Roths or is a draw. What you assume about the future makes a huge difference.

As I mentioned before, I have some experience with some clear exceptions for Roth conversions. Some simple guidelines: Consider converting in a year when your income is severly depressed. Consider converting if your future income tax rates are going to go through the roof (high income professionals - such as two lawyers in high income practices who are not likely to see lower tax rates when their income and assets climb. Consider converting if you have unusual investment opportunities - I have a friend who has been earning over 35% annually since 1998 in his converted Roth (a large account) which will throw him forever into the top tax bracket - a circumstance that not even 1 in 500 is likely to face. Don't convert if your conversion would be taxed in the state where you live but you plan to move to one of the state without an income tax (NH, TX, FL, etc.). Don't convert if you expect that your income or tax rate in some future years will decline (wait until then, run the risk that the rules and eligibility hold). Consider converting if you are luck enough to live in a state with no income tax but may move to a state with income taxes in the future. Never convert if you can't pay the taxes with non-IRA funds.

Finally, DO NOT CONVERT if you have not run your idea past one or more neutral parties like an accountant or a financial advisor. Get a second and third opinion about your choice.

Note this applies to Roth conversions. Roth contributor accounts are almost always a great idea and are influenced by completely different factors.