Short-Term vs. Long-Term Tax Savings

Yesterday’s post discussed an issue that arises frequently in different guises. Yesterday, the specific question was whether the cost of delaying a Roth conversion from 2009 to 2010 outweighs the benefit of 2010’s special sale on Roth IRA conversions.

Now here is another similar question in a form that arises all the time, not just in 2010. Convinced of the long-term benefit of Roth-ification, you have decided to Roth-ificate a large pre-existing traditional IRA you’ve accumulated over many years. Fortunately, you have a stash of funds in a taxable investment account to pay the tax cost of doing so. If you do it all at once, some of your IRA will be Roth-ificated at your current marginal tax bracket of, say, 28%, but some will be layered onto the next tax bracket of 33%; and maybe some will cost even more, at 35%. Alternatively, you can spread out the process over a few years and keep the tax cost of the whole thing at 28%. Which is your better option?

It turns out, you have to know a lot about how you approach your retirement planning before you can even begin to answer the question. Consider this chain of reasoning:
• Obviously, an important factor is the rate at which you project your traditional IRA will grow.
• But wait! Another important factor is the rate at which you project your taxable investment account will grow, since this is the savings bucket which will be diminished each time you pay the tax cost of Roth-ification.
• But wait! Those two factors depend on your asset allocation. Obviously you are going to project a different growth rate for your fixed income investments than for your equity investments. So what’s your projected long-term asset allocation?
• But wait! You should be rebalancing your asset classes periodically—at least I hope you are—particularly after you have spent a big chunk of dollars out of your taxable account for the privilege of converting a piece of your traditional IRA to a Roth IRA. So do you intend to rebalance after each annual tax expenditure?
• But wait! Which asset classes are in each of your savings buckets? Maybe you wisely engage in asset location planning as described in February 13’s post, so that you prefer to house your equities in one type of savings bucket and your fixed income in a different savings bucket. So to answer the questions posed in the first two bullet points, you have to know your asset location plan. What’s your asset location plan?
• But wait! You can’t properly adopt an asset location plan until you know which savings bucket you plan to tap first after you retire. In February 12’s post I called that spigot planning. So what’s your spigot plan?
• But wait! How can you adopt a spigot plan without knowing how much you plan to spend each year; how do you plan to make those savings buckets last a lifetime? So you have to know your retirement spending plan. What’s your retirement spending plan?
• But wait! You can’t really adopt a retirement spending plan until you project how much you’ll have at retirement. For that, you need a retirement saving plan—how much you plan to save each year during your working years. What’s your retirement saving plan?
• But wait! Your annual retirement savings have to go somewhere. You’ll need to prioritize which savings buckets to add your annual savings to, as illustrated in March 2’s post. What’s your bucket destination plan?

It’s all a vast seamless web, isn’t it. It’s like you have to project the entire course of your life in order to make a seemingly simple tax decision. No wonder people are short-sighted. It’s so much easier.