The Year of the Roth

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Until 2010 arrived, you couldn't have a Roth IRA if your income exceeded certain limits. That restriction is gone. Now anyone with a traditional IRA can convert it to a Roth. But should you? 

Background

Roth or traditional, the central advantage of an IRA is tax deferral. Earnings accumulate and compound free of current tax, so the total value grows faster.

An IRA is fed by annual contributions made out of employment income (salary, wages, and fees). With a traditional IRA, the employment income you contribute escapes current tax. Tax time for the contributions and their earnings comes when you withdraw the money. With a Roth IRA, you pay tax on the income you contribute, but the contributions and earnings eventually can be withdrawn tax-free (provided the Roth is at least five years old when you take the money out).

The ceiling on contributions to either type of IRA is $5,000 per year ($6,000 if you've had a 50th birthday party).

Two other age milestones apply. Withdrawals you make before the year you reach age 59½ are subject to a 10% excise tax. And with a traditional IRA (but not a Roth), you must begin making "Required Minimum Distributions" when you reach age 70½.    The question of whether to convert a traditional IRA to a Roth isn't simple. Even so, for most readers the answer turns out to be an emphatic YES.

A good way, perhaps the best way, to cut through the complexity and discover why the YES is so loud and clear is to imagine you’re starting from scratch. If you were just beginning to build an IRA, and if the rules would allow you to choose between making a deductible contribution to a traditional IRA or a non-deductible contribution to a Roth IRA, which would be better?

Tax Rates

A traditional IRA is a holding tank for taxable income. A Roth is a reservoir of tax-free income. Both give you the benefit of tax-free compounding.

Assume, for the sake of simplicity, that you are going to cash out your entire IRA when you reach age 70½. In that case, the choice between contributing to a traditional IRA or to a Roth is nothing more than a bet on tax rates. If your tax rate goes up, the Roth will give you more after-tax spendable cash when you reach age 70½. If your tax rate goes down, contributing to a Roth will turn out to have been a mistake. If your tax rate holds steady, your decision won't matter.   

A simple example illustrates the last point. Suppose that:  

  • You are 40 years old.
  • You have $5,000 of pre-tax employment income to contribute to an IRA
  • The IRA will earn 8% per year.
  • You are and always will be in a 40% tax bracket.

If you contribute to a traditional IRA, it will be worth $50,313 when you reach age 70½, but after paying tax on the withdrawal, you’ll be left with $30,188 to spend. On the other hand, if you pay tax on the $5,000 now and contribute the remaining $3,000 to a Roth, you'll eventually discover that you really only needed one hand – since the spendable cash waiting for you 30 years later will be the same $30,188.

  Traditional IRA Roth IRA
IRA budget 5,000 5,000
Current tax on IRA budget  None 2,000
Net contribution 5,000  3,000
Gross value after 30 years 50,313 30,188
Tax in 30 years 20,125  None
After-tax value in 30 years 30,188 30,188

In the example, the result is a tie. Assume any starting age, any earnings rate, and any constant tax rate, and you’ll still get a tie.

A number of factors break the tie.

Effective Size

Even if you assume a constant tax rate, contributing to the Roth will be a better choice because the contribution limit on a Roth is effectively much higher. Consider the example just above. The rules wouldn’t limit you to contributing $3,000 to a Roth; you could contribute $5,000 of after-tax income to it.

At a 40% tax rate, the government effectively owns 40% of your traditional IRA, so 40% of each contribution goes to building the government’s share. With a Roth, you own the whole thing.

Life After 70½

You probably have important assets outside of your IRA or other retirement plan, assets that are fully exposed to taxation. Regardless of your age, it makes sense to draw on those other assets for living expenses before touching tax-protected IRA money. Ideally you should spend the last outside dollar before you spend the first IRA dollar. With a Roth, you are free to do just that. With a traditional IRA, the rule on Required Minimum Distributions deprives you of that freedom when you reach age 70½.

The RMD rule eventually forces you to pull money out from under the tax-deferral canopy of a traditional IRA. But Roth money can stay sheltered until you need it, regardless of your age.

High Odds on Higher Rates

The farther out you look, the less confident you can be about tax rates. You may not like it, but you have no choice but to bet on where rates are headed. So let's be sensible handicappers. As you try to peer into 2011, 2012, 2020, or – strain at the binoculars – 2040, do the odds favor the low-tax horse or the high-tax horse?

For 2011, High Tax has already galloped into the stretch. Low Tax, meanwhile, is trembling behind a curtain, and the vet is reaching for his pistol of mercy.

The "Bush" tax cuts are set to expire at the end of this year. Unless new legislation extends them (unlikely, given the attitudes of the current White House occupant), the top rate will bob up from today's 35% to 39.6%.

Try to see a few years beyond 2011, and what you find is a landscape of huge federal deficits – not a plausible background for lower tax rates.

If that picture of where tax rates are headed makes sense to you, then the case for contributing to a Roth rather than contributing to a traditional IRA gets even stronger.

Move the Previous Question

We started with the puzzle of whether you should convert an existing traditional IRA to a Roth. But all the answers so far have been about whether to send your 2010 contribution to a traditional IRA or to a Roth.

The contribution question and the conversion question are the same. Converting a traditional IRA to a Roth (pay tax on the income now) instead of staying with the traditional IRA (pay no current tax) has the same effect as contributing taxable income to a Roth (pay tax on the income now) instead of contributing it to a traditional IRA (pay no current tax). So any argument for sending your 2010 contribution to a Roth is also an argument for converting your traditional IRA to a Roth this year.

Easing the Pain

Converting a traditional IRA to a Roth usually means writing a large check for the tax bill. But by positioning your IRA properly, it’s possible to cut that tax bill by a big margin.

Most IRAs are sponsored by a financial institution – bank, broker, mutual fund family, or insurance company. Not surprisingly, they are limited to the investments or investment services the sponsor wants to promote.

An "Open Opportunity" IRA takes you past the limitations of a sponsored IRA. An Open Opportunity IRA owns a single asset – a limited liability company that you manage yourself. It, not the custodian, holds the investments you want.

The Open Opportunity format opens many doors that are closed to an ordinary IRA. You're free to invest in almost anything – real estate, tax liens, American Eagle gold coins (store them personally anywhere in the world), private placements, equipment leasing, foreign real estate, intellectual property that you buy or create. You name it. Your Open Opportunity IRA can even have its own foreign holding company.  

Using a limited liability company to hold IRA investments also enables you to reduce the tax cost of a Roth conversion by adapting a valuation strategy commonly used in estate planning.

A now well-established and conventional estate-planning strategy is to put assets into an LLC having features that suppress the fair market value of ownership shares in the LLC. Such features often include restrictions on transferring shares, restrictions on distributions and a requirement for a supermajority, or even unanimity, to dissolve the LLC. Achieving a discount of 35% (the value of the shares vs. the value of the assets inside the LLC) is common, which reduces the related gift or estate tax by 35%.

With an Open Opportunity IRA, you can apply the same strategy to a Roth conversion, since it is the fair market value of the assets being transferred to the Roth – the shares in the LLC – that gets taxed. The result can be a big cut in the tax cost of making the conversion. 

Timing

If converting to a Roth looks like the right move, the best time to do it is soon. An investor who makes a Roth conversion in a given year is allowed to undo it at any time before his tax return for the same year is due. This amounts to a wait-and-see period on investment performance, and the longer the period is, the more valuable it can be.

Suppose you make a Roth conversion and the investments do poorly between now and the time your 2010 tax return is due. In that case, you could, and probably should, revert to a traditional IRA. There would be no tax on the roundtrip. On the other hand, if the investments perform well between now and the due date, you would simply stay with the Roth and congratulate yourself for having converted early, when the IRA was worth less and the tax bill was smaller.

Don’t rush to convert your traditional IRA to a Roth, but don’t put off the decision. As it is with so many other matters, if it makes sense to act, sooner is better.

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