More on Short-Term Tax Savings vs. Long-term Benefit

Editorial note: This post was supposed to appear on June 23.

Yesterday’s post discussed how there is often a trade-off between short-term tax savings and long-term tax benefit. Paul Anonymous identified one particular manifestation of that issue as he considers whether to contribute to a non-deductible IRA now, or wait until just before he converts it to a Roth IRA in early 2010. The former approach likely has a slightly higher short-term tax cost. The latter approach likely has a slightly higher long-term tax benefit. How do you know which outweighs the other?

Before providing some rules of thumb (which, as we all know, are always wrong), a couple of observations.

Observation #1: You can never know for sure. Accept that, as in all things in life, you must make a decision in the face of uncertainty about what the future will bring. All you can do is make your best guess.

Observation #2: (This one is hard for many people to swallow.) Your guess must necessarily be based on long-term projections. That’s because long-term benefits can only be assessed in the long term. Duh.

Observation #3: Be sure you’re comparing the right output. It’s not which approach pays the least in taxes. Rather, for most of us, it’s which approach leads you to the highest after-tax retirement spending. (For a lucky few—the wealthy—the right output to measure is which approach leads to your children’s highest after-tax wealth.)

So how do you know if you benefit more from a lower short-term tax or from the long-term benefit of a larger Roth IRA? Here’s a couple of rules of thumb:

Rule #1: If you’re 20 or more years away from retirement, then you’ve got enough time to benefit from long-term savings. Pay the higher tax.

Rule #2: If you’re wealthy, regardless of age, then you’ve got enough time to benefit from long-term savings. By “wealthy” I mean either of the following: (1) you have enough assets outside your tax-favored retirement plans to meet your spending needs during your lifetime, and don’t ever need to tap into your tax-favored retirement accounts, except as required by law; or (2) you are spending as much as you care to during your lifetime, and any additional resources will end up in the hands of your beneficiaries after your death. While both categories of "wealthy" benefit from long-term savings, the latter category (the "really wealthy" (?)), derive a greater degree of benefit than the former.

Unfortunately, those two rules of thumb don’t nearly cover the whole waterfront. They still fail to address Paul Anonymous’ situation and that of most readers of this blog. Most of us are not wealthy, and are either at or too near retirement to make use of Rule #1. In that case, the only approach I can recommend is to do a full-blown long-term financial projection. Or, short of that, do what Paul Anonymous is doing and go with your gut instinct.