Another Good Roth Conversion Issue

In a comment to June 18’s post, Paul Anonymous has raised another good issue. (Thank you, Paul—whoever you are—you are a veritable fount of good ideas for blog posts.)

Paul’s situation presents a tax-planning issue that comes up all the time, in many sizes and many variations. When is a short-term tax cost outweighed by a long-term benefit? The question is simple. The answer? Not so much.

Here’s Paul’s version of the issue. He plans to make $11,000 nondeductible IRA contribution for 2009 (between him and his spouse, one of whom has reached age 50). He will then convert all his IRAs to Roth IRAs in 2010, when the rules change and the Roth dam bursts. If he contributes the $11,000 now, the tax cost of his Roth conversion will go up on account of any investment earnings between now and the conversion. Paul expects that that Roth conversion tax cost will exceed the tax cost of enjoying those investment earnings outside the shelter of the IRA. Why? Because he intends to invest his $11,000 in stocks, and, at least for the time being, the tax rate on dividends (and long-term capital gain) is lower than the general tax rate that applies to Roth conversions.

(An aside here. Actually, the tax rate on a 2010 Roth conversion might in fact be lower after you factor in the special tax deal on 2010 Roth conversions, as described in February 28’s post. The value of delaying tax by a year and a half brings the effective tax rate down a bit. But for the sake of discussion, let’s assume the tax cost of converting those investment earnings to a Roth account exceeds the tax cost of earning dividends outside the IRA.)

So. Here’s the ubiquitous issue. Is it worth it to pay that extra tax to shift more dollars from your taxable account into your Roth IRA? What’s more powerful—the short-term savings or the long-term benefit?

(Before answering, here’s another aside. The amount at issue here is truly miniscule. In terms of making a meaningful contribution to his future retirement security, Paul is planning to do two big important things with very favorable long-term consequences. (1) He and his wife are contributing the maximum ($11,000 in their case) to their IRAs. (2) And they are planning to convert their traditional IRAs to Roth IRAs in 2010. Way to go, Paul! So why am I even discussing the relatively minor issue of whether he makes the contribution now or just before the Roth conversion? How much could possibly be at stake? $100 investment earnings over the next 7 months maybe? Why am I wasting electronic ink? Just because it’s interesting to me; that’s why. I really need to get a life.)

So, anyway, what’s the answer? Well, it depends on many factors, so there is no one right answer.

But in my experience, after doing untold numbers of projections with varying degrees of precision, I find that the long-term benefit of shifting that hypothetical $100 into the Roth account often exceed the short-term cost of paying a greater rate of tax on an extra $100 in 2010. Or, more precisely, on half in 2011 and half in 2012.

A bit more on this tomorrow.