December 1, 2009
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“The wages of sin are death. But by the time taxes are taken out, it’s just sort of a tired feeling.”
- Paula Poundstone
With the new Roth conversion rules about to be lifted next year and a “one-time special offer” available to allow investors to spread the tax bite of conversion over two years, more and more Roth conversion calculators are showing up every day. Be wary. If you use one of these calculators, don’t say I didn’t warn you about how misleading the results can be.
As with any program, the output is only as good as the input, and some of those inputs are the assumptions the program uses in the analysis. These assumptions about the future (which is of course uncertain) can wildly skew the answer to make the Roth look artificially attractive.
Misleading Roth analysis
I recently reviewed a paper about Roth conversions written by a large, respectable investment firm. The paper summarized key criteria of what would generally be the circumstances where a Roth conversion, or use of the Roth, would make sense.
Paraphrasing the paper, the “best candidates for conversion” are those who have taxable assets to pay for the conversion, and face ANY ONE of the following circumstances:
- Their tax rates in retirement are unlikely to be materially lower than pre-retirement rates.
- They are converting at a young age.
- They will not have a material income need from the IRA, they will only need withdrawals from the IRA much later in life, or they are using IRA assets to fund an estate goal (no need for withdrawals at all).
The paper proceeded to calculate all sorts of significant advantages for Roth conversions and showed only a few cases where a small, incremental benefit was offered by continuing to defer taxes by not converting. . Much of the supposed cause for the Roth advantage is based on required minimum distributions (RMDs) which, along with their tax effects, can be easily simulated.
I am highly skeptical of the Roth’s promise for a few reasons. First, I fear that a future government will change its mind and revoke the Roth’s tax-exempt status. Understand that Roth conversions (or contributions) increase current tax revenue at the expense of future revenue. In essence, the government is mortgaging future tax revenue to collect them now.
Roll forward thirty years and imagine the justification Congress might argue for in applying a surtax on all of these Roth multi-millionaires who don’t pay any taxes at all. It would be rather tempting for Congress to make a “needs-based amendment” to the tax-exempt status. While I wouldn’t plan on this happening, I would not assume there is no risk of it occurring either… especially for those using Roths to accumulate significant estate assets.
Secondly, the new Roth conversion rules are an option for anyone to execute at some date in the future, and with a highly uncertain future, basic option theory and common sense dictates that we should not pay additional tax now with certainty if we can avoid it, unless there is a clearly compelling advantage to doing so. In the future, this new Roth conversion option for high earners may be repealed, but I would not rush to pay a huge tax bite now if I can defer executing that option until some later date when some of the uncertainties of time have passed or a repeal of the option is imminent.Finally, when analyzed properly, the supposed Roth advantage can actually be a detriment even where it is normally assumed to be advantageous, if an investor wants to be confident they can fund prioritized life goals and avoiding needless lifestyle sacrifice.
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