IRA: Roth vs. traditional

[SAM2]

I'm thinking about converting my traditional IRA to a Roth IRA before end of 2010. Anyone have input/advice?

As I understand it, if I convert to a Roth, then I will owe taxes on any investment gains over my contribution basis that have accrued while the funds have been in the IRA. Let's assume that's about $100,000 in investment gain (to keep the math easy), so I'd owe tax on $100k at my current tax rate. So the bad news is that I'd owe an additional $25k+ in taxes in 2010, but the good news is that I could draw down the IRA assets to pay those taxes. But the big benefit would be that any further investment gains in the new Roth IRA would be tax-free. And 20+ years of investment gain on the Roth IRA assets would be fairly significant.

At first, making the shift from traditional IRA to Roth IRA seems counter-intuitive to me, because I will be paying taxes on the current gain at my current tax rate, which I suspect is a higher tax rate than I'd have in retirement 20+ years from now. But the difference is that if I convert now, I'm paying today's tax rate on only $100k in gain. Whereas if I don't convert, then although I will be paying at a lower retirement tax rate (hopefully) and not paying for 20+ years, I will be paying taxes on $387k+ in gain (at 7% growth rate over 20 years) instead of just $100k.

Is all that correct? What am I getting wrong?

I've read some about the recharacterization benefit -- which sounds like a potentially savvy for balancing gains against losses -- but that might be too complicated for me. If anyone has thoughts on how to make that work, I'd love to hear those.

TIA

[Anonymous]

First of all, you can't draw down the IRA balance to pay the tax-- that would be an early withdrawal, triggering a 10% penalty.

Second, strictly speaking the math is the same. If you assume you are in a 25% tax bracket and say you have an account with $100,000 in it and no basis at all (because you took deductions for your contributions). If you put $75,000 ($100,000 less 25%) into a Roth today, and it grows 7% a year, and then you withdraw it tax free, you will have exactly the same amount after tax as you would if you left $100,000 in the account to grow at 7% a year, and then you withdrew it but paid 25% tax at the time of withdrawal.

If you really have a basis in your traditional IRA (i.e., you did not deduct your contributions), then when you withdraw money from it you won't pay tax on that basis, so the math will still be the same (but just because your IRA has increased in value over your contributions doesn't mean you have a basis for tax purposes).

One advantage of a Roth is if your tax rate will be higher in the future than it is now.

Another is if you can pay the tax out of other money (say you roll over that $100,000 and pay the $25000 out of other savings, now you are growing 100k tax free, not 75k, and you will end up with more tax free in the end). Effectively, contributing after tax money to a Roth means your contribution limit isn't $100k, or $5k, but that amount plus the tax you pay on it.

There are other advantages, such as no minimum distributions.

[SAM2]

Many thanks. This is helpful.

This just seems crazy:

Anonymous wrote:One advantage of a Roth is if your tax rate will be higher in the future than it is now.

It's hard for me to imagine having a higher tax rate in retirement than I have now. Indeed, I anticipate my tax rate will be lower.

This makes a ton of sense and is very helpful:

Anonymous wrote:Another is if you can pay the tax out of other money (say you roll over that $100,000 and pay the $25000 out of other savings, now you are growing 100k tax free, not 75k, and you will end up with more tax free in the end). Effectively, contributing after tax money to a Roth means your contribution limit isn't $100k, or $5k, but that amount plus the tax you pay on it.

If I understand you correctly, I'm effectively just increasing my max contribution limit by whatever taxes I pay now (or at least some function of that). So conceiving it that way, the real benefit of a conversion is not any sort of tax break, but rather an opportunity to increase the amount of money that will compound tax-free. Is that correct?

[Anonymous]

SAM2 wrote:
If I understand you correctly, I'm effectively just increasing my max contribution limit by whatever taxes I pay now (or at least some function of that). So conceiving it that way, the real benefit of a conversion is not any sort of tax break, but rather an opportunity to increase the amount of money that will compound tax-free. Is that correct?

Well, that's the way I think of it, but there's also the possibility that taxes will go up (some would say it's not a question of whether but how much), so even if you think you will have less taxable income, you might not be in a lower tax bracket after all. Some advisors are starting to tell people to try and be "tax diversified" (i.e., have some after tax money and some before tax money in their retirement accounts) because you never know what'll happen.

[Anonymous]

Sam2, In addition to the previous poster's comments, keep in mind that once you convert and the converted account loses value, you will never get the taxes back.

Advantages of a conversion:

- Pay taxes now when you can afford it and not in retirement.
- No minimum required distribution in retirement
- Roth withdrawal will not affect income in retirement so you get max social security

Disadvantages:
- Tax in retirement may be lower; So you pay more taxes now rather than later.
- If the converted account loses value, you are screwed; The government got it's share of the tax while you are left with a reduced account

My advice would be to convert piecemeal over several years so you can afford to pay taxes out of your income as opposed out of the IRA. I don't beleive there is a conversion penalty but paying taxes out of the traditional IRA does not make sense.