Myths
- Everyone Should Convert to Roth IRA
President signed into law the
Tax Increase Prevention and Reconciliation Act of 2005 on On May 17, 2006. One
of the provisions will allow all individuals to convert traditional IRAs
into Roth IRAs starting in 2010. Currently, only individuals with
an income below $100,000 can do this.
In reading acticles, some have said that this conversion
is a no brainer including Suzie
Orman. The main reasons that people give appear to be:
- Roth IRAs are taxed intially (when income is contributed or IRA is
converted) and not in retirement so investment returns for Roth IRAs
are not taxed
- Tax rates may increase in the future so it is better to get taxed now
- Roth IRAs can be used as an emergency fund
Before you go off to convert your IRAs, let's take a closer look at each
of these reasons:
- Roth IRAs are taxed intially (when income is contributed or IRA is
converted) and not in retirement so investment returns are not taxed
Not being taxed on your investment returns sound very promising. Yet,
as I have written in Power
of 401(k)s and IRAs, if tax rates are consistent, then from an
investment return perspective, 401(k)s and IRAs are simiar. Let
me show why this is true. Assume
that a person age 35 invests $5,000 in each tax deferred vehicle
which all earn 8.5% annually and he takes his money out at age
65. Assume the person is also taxed a flat 30% now and in
the future.
In a 401(k) and IRA
Investment is put into the vehicle tax-free at
age 35: $5,000
Investment grows with interest tax-free to age 65: $5,000 x
(1.085)^30 years = $57,791
Money is taxed when withdrawn at age 65 : $57,791
x (1 - .30 tax rate) = $40,454
In a Roth IRA
Money is taxed at age 35 when earned as income: $5,000 x (1
- .30 tax rate) = $3,500
Investment grows with interest tax-free: $3,500 x (1.085)^30
years = $40,454
Money is not taxable when withdrawn at age 65: $40,454
As you can see each vehicle while end up with the same amount at
age 65 ($40,454) under a constant tax rate. One may wonder
how this can be when the tax for the Roth IRA was only $1,500 ($5,000
x .30 tax rate) while the 401(k) and IRA the tax is $17,337 ($57,791
x .30 tax rate). This is because the government will take 30%
of the money either at the beginning or at the end. Now, imagine
your money as a pie circle. If the money (pie circle) expands
outward at similar rates, the government will take its 30% slice
whether it is on the smaller pie or larger pie. In the end,
30% of the pie is still gone due to taxes. Thus, in an IRA,
Roth IRA or 401(k) plan, your share is the remaining 70%.
- Tax rates may increase in the future so it is better to get taxed now
First, this is not a given. And, if they do increase, the
effect on 401(k)s, IRAs and Roth IRAs are not certain. For
example, tax increase can be done by increasing sales tax, capital
gain taxes, or reduce tax deductions and exemptions which will have
no effect on these tax deferred savings vehicles. And, if tax
rates do increase in the future, the tax savings from being taxed
at lower rates may not offset the cost of converting your IRAs all
at once. Let me show you why.
Assume you are earning $60,000 and have $200,000 IRA. When
you convert, the IRA is reported as taxable income. The regular
income tax on a simplified basis would be:
| |
No Conversion
|
Conversion
|
| Income |
$60,000 |
$260,000 |
| Exemption |
$6,600 |
$6,600 |
| Taxable Income |
$53,400 |
$253,400 |
| Tax on single (married) |
|
|
| 10% up to $15,100 |
$1,510 |
$1,510 |
| 15% up to $61,300 |
5,745 |
6,930 |
| 25% up to $123,700 |
0 |
15,600 |
| 28% up to $188,450 |
0 |
18,130 |
| 33% up to $336,550 |
0 |
21,434 |
| 35% over $336,550 |
0 |
0 |
| Total Tax |
$7,225 |
$63,604 |
As you can see, there are significantly more taxes involved with
an IRA conversion. However, this is not the real issue because
the IRA would have needed to be taxed in retirement. The key
is that for $200,000 for the IRA conversion, the person is paying
$56,349 in taxes (or 28% tax rate). In addition, there is state
and local income taxes due as well. The question is will you
be paying at a lower or higher tax rate in retirement. If lower,
then you should not convert to a Roth IRA. If higher, then
you should convert now. In some cases, it may be lower
because of the graduated tax scale (however, each situation
is different).
Example of tax in retirement:
Assume: $60,000 in Income with $24,000 for Social Security, $14,000
in non-retirement income (work or interest in other investments
&
$22,000 in Roth
IRA or IRA income)
| |
No Conversion
|
Conversion
|
| Income |
$60,000
|
$60,000
|
| Income Subject to Taxation* |
$14,000 |
$56,400 |
| Exemption |
$6,600
|
$6,600
|
| Taxable Income |
$7,400
|
$49,800
|
| Tax on Joint Income |
|
|
| 10% up to $15,100 |
$740
|
$1,510
|
| 15% up to $61,300 |
0
|
5,205
|
| 25% up to $123,700 |
0
|
0
|
| 28% up to $188,450 |
0
|
0
|
| 33% up to $336,550 |
0
|
0
|
| 35% over $336,550 |
0
|
0
|
| Total Tax |
$740
|
$6,715
|
In this situation, you are paying $5,975 more in income taxes for
$22,000 in IRA distribution (27% tax rate).
|
