I just finished EOY tax planning sessions with my clients, and Roth conversion was one of the topics. It reminded me how confused most investors are about Roth and prompted me to write this long post. Since Roth-related issues vary from very basic to very complicated, so will my post.
1. What is Roth IRA
It is not some other kind of retirement account. For example, 401(k) and IRA are two very different kinds of retirement accounts. However, Roth IRA is just an IRA. It works exactly the same way as a traditional IRA:
- you can contribute money into it every year, up to $6,000 (the limit changes from year to year and depends on your age)
- the account always belongs to one person, so husband and wife will have separate IRAs
- while your IRA money is invested and growing, you pay no taxes on your investments
- if you try to take the IRA money out before you turn 60 (well, 59 1/2 if we want to be exact), you usually pay a 10% penalty, with some exceptions
- your IRA can be self-directed, which allows you to invest in businesses and real estate and not just stocks and mutual funds
Everything above applies to both traditional IRAs or Roth IRAs. Their only critical difference is in how they are taxed.
2. Roth IRA v Traditional IRA taxation
Traditional IRA. You put $6,000 money into your IRA today. You deduct (usually, but not always) this $6,000 from your current year's income. As a result, you pay less taxes for this year. You invest this $6,000 into something, and 20 years later it becomes $20,000. During your retirement, you take this $20,000 out. When you take it out, it becomes taxable income to you. Thus you will eventually pay taxes on the entire $20,000.
Roth IRA. You put $6,000 money into your Roth IRA today. You do NOT get to deduct this $6,000 from your current year's income. As a result, your taxes for this year are not affected. You invest this $6,000 into something, and 20 years later it becomes $20,000. During your retirement, you take this $20,000 out. As you take it out, you owe absolutely no taxes. You will eventually take out the entire $20,000 tax-free.
With traditional IRAs, you do NOT pay taxes on $6,000 now, but you will pay taxes on $20,000 in retirement.
With Roth IRAs, you do pay taxes on $6,000 now, but you will NOT pay taxes on $20,000 in retirement.
3. Is Roth IRA really superior?
Many financial planners and CPAs make this conversation focus on future tax rates vs. today's tax rates. They often assume (incorrectly, in my opinion) that you will need less annual income in retirement than you need today. If so, then your tax bracket in retirement should be lower, so you're better off paying taxes in retirement than today. Roth wins.
Then, there's this common notion that financial planners are missing the point, and that Roth is infinitely superior to traditional. Here's how this argument goes: if your $10k investment turns into $100k - who cares what the tax rates are? You are always better off paying taxes on $10k than on $100k, regardless of rates and regardless of when.
Who is right? Both. The trick is to compare apples to apples. Roth was designed to be equivalent to traditional, and it actually is! - as long as taxes are taken out of retirement money.
Example. Let's consider a $10k investment that grows tenfold while inside an IRA for many years. (No relation to the 10X crap from you know who.) Let's assume 20% tax rate for simplicity.
Traditional IRA. No taxes now, so you invest the entire $10k. It becomes $100k. You have to pay $20k in taxes and are left with $80k.
Roth IRA. You pay $2k in taxes now and have $8k left to invest. It becomes $80k. No taxes to pay, so you take the entire $80k out.
See how both roads take you to the same place?
In reality, this is not how we behave or think. We do not subtract $2k in taxes from our $10k contribution. We pay the $2k tax from some other money, and we still contribute the full $10k. And then, we end up with $100k of tax-free money instead of $80k of tax-free money. Huge win for the Roth, it seems.
Basically, we're cheating, and it's not apples to apples. We are really investing $12k into Roth, not $10k. No surprise that Roth wins by a mile when we give it an initial boost in form of pre-paying taxes.
That said, if you have extra money to pay the tax upfront, and you're then choosing between $10k into a Traditional and $10k into a Roth - then surely it should be Roth.
4. Roth conversion
You're allowed to convert your existing traditional IRA accounts into Roth accounts. Under current tax law, you can do it for any amount and at any time.
Example. Years back, you twice contributed $5k into your traditional IRA, $10k total. By now, this account slowly grew into $15k because you kept it in relatively safe investments with modest growth. You're ready to make your IRA self-directed and start aggressively investing it in real estate notes and options. In couple years, you expect it to become at least $100k, maybe more.
You convert it into a Roth IRA now. You will owe taxes on $15k of extra income this year. However, in the future, when this account mushrooms into $100k, $500k or $10M - the money will stay tax-free forever. The only catch: you will owe taxes on $15k now.
Re-read my discussion of #3 above. If the taxes due on this $15k were to come out of the $15k itself - you would not gain any long-term advantage. However, nobody takes money out of the converted $15k account. (By the way, you would be subject to a 10% penalty if you do.) You would pay the tax from you other money, effectively subsidizing your retirement indirectly. So, if you have the cash for taxes - it's usually a good move.
The remaining question is when to do it. Now, in December, or wait until January? Here is how you decide.
- if your income this year was lower than usual, maybe due to Covid, then you want to convert in December, so the income from conversion is taxed at this year's lower bracket
- if you plan to quit your W2 job next year, then maybe your next year's income is likely to be lower. Then it's probably best to wait and have your Roth conversion taxed at the lower rate of next year
- if you plan to double your business next year - convert now and use this year's rate
- if you believe that the new administration will increase tax rates for next year - convert now to lock into today's rates
- if you expect to not have the cash for the extra tax - maybe wait
And remember that you can split the conversion: do some of it this year, and the rest of it later. Of course, this assumes you can predict the future. More on that below.
Important warning: all of the discussions so far assumed that your traditional IRA accounts contained only deductible contributions. In other words, every time you contributed to your IRAs in the past, you took a matching deduction on your taxes. This is not always the case, however. If your IRAs had any non-deductible contributions, Roth conversion (and your IRA taxation in general) becomes much more complicated. Don't DIY it, get professional help. Ditto if you're not sure whether or not your IRA contributions were deductible.
The above warning also applies to the so-called "backdoor Roth contributions" when you have any non-deductible money in any of your traditional IRA accounts. If you don't know what this means, it probably does not apply to you.
5. Is Roth for IRAs only?
No, you can also have a Roth 401(k), and it works basically the same way. If your employer offers you a Roth 401(k) option, take it. If you have your own Solo 401(k), consider turning it into a Roth 401(k). Both ways, you will have to pay more taxes today, but it will pay off eventually.
If your plan allows it (not all of them do), consider converting your existing 401(k) balance into Roth 401(k). You will owe taxes on the conversion, the same as we discussed for Roth IRA conversion.
6. About the future.
Some of y'all believe we have no future. Assuming that we still do, remember that everything we discussed depends on what happens in the future. As 2020 showed us, we should not overestimate our forecasting abilities.
Let's start with the biggest risk of all: will the Roth concept survive? See, currently Roth has no limits on tax-free distributions. Whether you grow your Roth account into $50k or $50M - all of it is tax-free at withdrawal under today's tax law. Especially with self-directed IRAs, your retirement money can grow dramatically. The bigger your Roth account gets, the more you will love the tax-free distributions from it.
In case you live under the rock, such "tax loopholes for the rich" have been under attack for a very long time. With the Democrats taking over and the overall social trends, I expect these attacks to intensify and eventually succeed. Roth is unlikely to die, but it could be substantially handicapped by future legislation. I think it's possible that we will see some kind of phased-in taxes on Roth distributions once they exceed certain thresholds. I want to be wrong on this particular prediction, but what if I'm right?
The already mentioned administration change brings with it a serious threat of an overall increase of tax rates, especially in the higher income zone. How much of that will Joe Biden be able to implement and how soon is anybody's guess. If you guessed "zero" and "never" - I suggest you guess again.
Besides a promise to raise tax rates, Biden's initial tax plan includes other proposals to revise the current retirement savings system. One of his proposals is rather fundamental: to replace current deductibility of pre-tax IRA and 401(k) contributions with refundable credits. If you recall the history of the 2017 Trump tax reform, campaign promises and early proposals had very little to do with the eventual tax law changes. As of today, I do not consider any of Biden's tax ideas a reliable indication of the future tax law, but who can tell. This entire post might become obsolete one year from now.
However, it's not my post I worry about. Your retirement plan may become if not obsolete, then at least substantially affected.
For those of you who are already certain about our future - keep stocking up on ammo and toilet paper. Unfortunately, can't buy it with your IRA money, even if self-directed.
I have a question.
If you are in an employer plan that permits a Roth contribution regardless of income levels (unlike an IRA Roth which only permits contributions at fairly low levels of income), when does it make sense to choose Roth?
I give up a pretty sizeable income tax reduction flowing from W-2 upfront if I elect Roth as I'm at the high end of income tax rates at this point in my tenure.
Additionally, under the specific plan rules I believe I can't withdraw funds separately from the Roth and non Roth plan accounts. I must draw ratably from both when I do make withdrawals in retirement so I can't separately time any distributions.
If I were taxed currently at low rates, had 40 years before retirement yet to go and could time separately my Roth and non Roth plan account distributions then I'd definitely go Roth, but otherwise I'm taking my income tax reduction now.
You asked a question and answered it yourself. Does not sound like you really needed my input. :)
But in case you did - I disagree. And I explained my thinking in the above post. Yes, it costs you in taxes at a high rate, but you end up with an investment that grows tax-free rather than tax-deferred. Rates become irrelevant in this case since it's not apples to apples.
Ok good enough.
Yes I think we will disagree (in my case) as the time remaining for compounding for me is realatively short and my rate of tax paid after I stop working will likely be significantly lower since what causes my rates to be high currently is limited to employment income, the rest of my income although considerable will nearly all be indefinitely deferred the way I invest and likely will remain so through retirement until death.
I'm actually finding that it's possible to pay with proper planning almost as little tax outside a Roth (or any IRA for that matter) than within it.
I enjoyed reading the above post and agree with the majority of the information.
One thing that usually comes up (gets debated) when I'm discussing Roth with people I know in the FIRE (Financial Independence Retire Early) community, is their strong preference to contribute 100% of all retirement funds pre-tax to the extent possible. Their logic is that they will be able to convert the majority, if not all, of it at 0% tax rates and that it is effectively a Roth contribution. @Michael Plaks post above describes why this is not necessarily the case, but we'll leave that aside for the moment.
Most FIRE people think it's foolish to voluntarily pay taxes upfront for the 0% tax Roth conversion ability above. These are
(some of) the same people (my buddy is one of them) who think that they will always qualify for subsidized healthcare as long as "their income can be controlled," and that there won't be any asset-based testing or rule changes in the future. My stance on it is that the government surely will change the rules at some point and that if you can contribute Roth or convert to Roth at a "reasonable" tax rate, that it's probably better to do that now. The question is what is "reasonable" - 12% federal, 24% federal, anything below 37%? Very subjective. Very much dependent (at least partially, in my opinion) on future tax rates, which no one really knows but I think many of us would agree tax rates are likely going up.
"Tax diversification" is something else often discussed - having investment assets spread among taxable, tax-deferred, and tax-free (Roth) - to better manage whatever the future holds and give yourself options. This sounds great in theory, but the majority of people with typical retirement plans out there have money in tax-deferred vehicles. One of the things I try to keep a running inventory of is my taxable vs. tax-deferred vs. Roth breakdown in terms of percentage in each bucket relative to the total. I actually need to update this again this year. One thing I've found over the years is that since the employer-matching contributions (for those lucky enough to have one) have a tendency to build up the tax-deferred bucket. Some people commonly misunderstand that just because your contributions are 100% Roth (assuming they are), your employer matching contributions will still be 100% pre-tax no matter what. My employer effectively gives us a 9% match (6% match $1 for $1 on contributions and 3% employer automatic contribution), all of which is 100% pre-tax. So no matter what I contribute (assuming it's at least 6%), 100% of their 9% is going in that pre-tax bucket. Perhaps this is another reason to consider making your own contributions as Roth contributions to further balance out these "buckets."
My particular plan does not offer an in-plan conversion feature mentioned as a possibility in the original post. If it did, I would likely consider doing at least a partial conversion this year as my income did drop fairly substantially. Unfortunately, since I rolled my Traditional IRA into my 401(k) plan years ago (yes, you read that right) to avoid the IRA aggregation rules on backdoor Roth IRA contributions (since my income has been over the threshold historically), my pre-tax money is effectively "trapped" inside my 401(k) plan until I leave my current employer or otherwise meet a distributable event which allows me to do a Roth conversion.
In the meantime, it does make my choice a little simpler because it only affects current/ongoing contributions - pre-tax or Roth. This year, I chose pre-tax. I didn't expect my income to drop so dramatically; I actually expected it to increase substantially. A lot of us didn't expect a lot of things that happened in 2020. If I had to go back and do it all over again, I probably would have chosen Roth.
I have no clue what 2021 entails (who does?), but I plan to change my 2021 contributions to Roth 401(k) going forward. Why? 1.) I believe tax rates are going up. 2.) I want to further try to balance my pre-tax and Roth "buckets" for the future. 3.) I agree with Michael's point above about effectively being able to "contribute more" to a Roth versus pre-tax account and the "edge" this provides. 4.) As much as I'm all about FIRE (or at least the FI part), I do not believe that I can contribute 100% pre-tax and ultimately convert at 0% over time based on my individual situation (my buddy on the other hand who is planning to do this is in a different situation and it's POSSIBLE, but in my opinion not PROBABLE long term).
Thank you, @Mark S. , for illustrating why most people need the professional guidance of either tax accountants like me or financial planners like you. :)