Money Management and the Economy

Sunday, February 15, 2009

Now is a good time to roll over your IRA to Roth IRA

You aren't smarter than the market. It really is that simple.

One of the interesting aspects of the recent collapse in stock values is that it makes it a good time to consider rolling your traditional IRA over into a Roth IRA and paying the taxes on the lower valued stock before they go back up. Of course, that assumes they will go back up before you retire.

For people who don't pay attention to this sort of thing, the basic difference between a Roth IRA and a traditional IRA is how you pay taxes on them.

With the traditional IRA you put your money in an account for retirement and you don't have to pay any taxes on it. Or, looked at another way, you can deduct the contribution from your income taxes. You also don't have to pay taxes on any of the earnings from the investment while they accrue. But when you go to take money out of that account, you have to pay income taxes on the money you withdraw just as you would any other income you had earned. So, while you save money in the short run, you are fully taxed on both your investment and any earnings when you take the money out. And, with a traditional IRA, you are required to start taking the money out so you can't avoid paying taxes forever.

The Roth IRA works basically in reverse. You pay taxes on the money before you put it into the account. You don't have to pay any taxes on any earnings as they accrue. And you don't have to pay any more taxes on either the principal or the earnings when you withdraw them in retirement. There is also no required withdrawal, so they can go on generating tax free income the rest of your life.

Generally speaking, and the devil is in the details, you are better off with the Roth IRA if you expect your nominal tax rate to be as high or higher in retirement as it is now. Of course, none of us really know what our tax rate will be in retirement. That will be based on a bunch of factors, including decisions by people we elect in the future. For that reason, there are people who argue that you should have "tax diversity" with some money in Roth accounts and some in traditional IRA's (or 401K's which are similar to the traditional IRA in how they are taxed). But the general argument, that Roth is likely to be a better deal if the market goes up remains true.

Why does this matter? Because most people can roll investments they made in a traditional IRA over into a Roth IRA. But they have to come up with the money to pay the taxes. And, that money can't come out of the money being rolled over without paying early withdrawal penalties on it.

So assume, like me, you have $10,000 in a traditional IRA and a nominal tax rate of 25%. If you roll that $10,000 over into a Roth IRA now, next year you will owe an additional $2500 in income taxes. So does spending $2500 now pay off? Lets look at three scenarios:

1) Your investments have zero return:

IRA 10,000 - taxes paid upon withdrawal $2500.
Roth 10,000 - taxes paid now $2500.

This is essentially a wash, although the IRA has the "advantage" that you can pay those taxes out of the money as you take it out. I put quotes around "advantage" because this seeming advantage also means you have less money to spend in retirement. That extra $2500 you use to pay taxes on the Roth now can also be looked at as additional retirement savings.

2) Your investments return 10%: (this gets trickier)

IRA 10,000 + $1,000 earnings. Taxes due on withdrawal $2750.
You also would make another $250 with a 10% return from investing the $2500 saved by not paying rollover taxes. But those earnings are taxed - taxes on earnings $62.50
Net to spend in retirement: 10,937.50 after taxes.

Roth $10,000 + $1000 earnings (no taxes)
Net to spend in retirement: $11,000 after taxes.

Of course, 10% isn't a great total return for a long term investment. What happens if you leave the money there for 20 years and it doubles in value?

IRA 10,000 investment + $10,000 earnings. Taxes due on withdrawal $5000.
You also would make another $2500 with a 100% return from investing the $2500 saved by not paying rollover taxes. But those earnings are taxed - taxes on earnings $625.
Net: 19,375 after taxes.

Roth $10,000 + $10000 earnings -
Net: $20,000 after taxes.

But what if you don't invest the $2500 you saved on taxes? Then you have considerably less to spend in retirement:

Net IRA - $15,000 after taxes.

So, it pays to roll over if you are still paying the same tax rate on income when you retire. On the other hand, if your nominal tax rate drops to 15% at retirement, you may be better off waiting. But only if you invest the money you save on taxes. Otherwise you will still have less money when you retire if you leave your money in the IRA.

But what happens if your investments LOSE money? Then you are almost certainly better off leaving your money in the IRA. And that brings us to the reason many people think now is a good time to make the rollover. Because the value of most IRA accounts has dropped dramatically their value is at a low point and the taxes on the rollover will be lower. Some people also believe that today's low stock values will mean higher returns in the future and, as we saw above, the higher the total return on your investment the greater the tax advantages of the Roth IRA.

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