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.

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.

Roth Conversion Questions

In a comment to May 15’s post, Paul Anonymous raises a number of questions about 2010 Roth IRA conversions. Good man, Paul, you're planning ahead! I’ll try to answer them.

Paul already has both a traditional and a Roth IRA. One question is whether you need to open a separate Roth IRA to hold the assets converted from a traditional IRA, or can you use the existing Roth IRA. The answer is that you don’t need to open a new Roth IRA. One acceptable method for converting a traditional IRA to a Roth is to transfer assets from an existing traditional IRA to an existing Roth IRA. That seems like the administratively easiest thing to do, rather than maintain two separate Roth IRA's needlessly. Although that won’t work if you want to keep the assets at different institutions. Then you’ll of course need separate IRAs.

Paul next asks a question about the wisdom of maintaining a small traditional IRA. Here’s the scenario. Paul apparently intends to convert all (or virtually all) of his traditional IRAs to Roth IRAs. He doesn’t say that explicitly, but that appears to be his plan. And apparently he does not expect to meet the qualification requirements for annual Roth IRA contributions—too much Adjusted Gross Income perhaps. So, looking to the future—2011 and beyond—Paul is planning to make annual traditional IRA contributions and then immediately turn around and convert them to Roth IRAs. Good planning! But that raises the question of whether he should leave some money in a traditional IRA—perhaps a nominal amount—so he doesn’t have to re-open a new traditional IRA every year. I think that’s a terrific idea, as it saves the administrative headache of opening a new account every year--a process that has gotten increasingly burdensome. Keep just enough in the traditional IRA to minimize administrative fees, and then convert the rest to a Roth IRA.

Paul plans to delay his 2009 nondeductible traditional IRA contribution until early 2010. At that point, he will make both his 2009 and 2010 nondeductible traditional IRA contributions, and then immediately turn around and convert them to Roth IRAs. Paul’s thinking is that by delaying the 2009 contribution, he will avoid investment earnings on that amount and reduce the tax cost of converting his whole traditional IRAs to Roth IRAs.

Not so fast, Paulie. I’ve got to disagree with your analysis there. If you keep your $5,000 in your taxable account for the rest of 2009, aren’t you going to earn some returns inside your taxable account—say $50? And then won’t that therefore generate an income tax. In fact, if you invest in interest-bearing investments, the tax you save on the Roth conversion will exactly equal the tax you’ll owe on your taxable investment earnings, so there will be no tax savings at all, plus you will have lost the opportunity to house the $50 inside that most valuable Roth investment environment. Even if you invest in equities, the earnings on which enjoy lower tax rates, the long run benefits of having the $50 inside the Roth environment easily outweigh the short-term detriment of paying a greater Roth conversion tax than a corresponding income tax on the $50 investment earnings. So if I were Paul, I would make my 2009 traditional IRA contribution now, and thereby divert that hypothetical $50 from my taxable bucket to my tax-exempt bucket.

An aside here. It appears that Paul is planning to convert virtually all his traditional IRAs to Roth IRAs in 2010. Would it still be his best strategy to make a 2009 nondeductible IRA contribution if he were planning to convert only a portion of his IRA's to Roths—let’s say 25% of his traditional IRAs? That’s a tougher question. Because then he would only get to recover 25% of his nondeductible contributions tax-free in 2010, and he’d have to wait until later years to recover the remaining 75%. Let’s say he makes a $5,000 nondeductible traditional IRA contribution in 2009, and then converts 25% of his traditional IRAs to a Roth in 2010. The amount he pays tax on is reduced by 25% of his cumulative non-deductible contributions, including the one from 2009. So he contributes $5,000—no deduction—and ends up paying a Roth conversion tax on $3,750. He’s just increased his taxable income by $3,750; he’ll eventually recover the other $3,750 tax-free, but it will take years for that to happen. Is that good planning? I don’t know. I suspect it is, but I think the issue needs some closer study. Look for more on this question in a future post.

Timing of Roth Conversion

In a comment to May 4’s post, “Financial Planner Atlanta” (if that’s your real name) raised a good question. How does the timing of a 2010 distribution from a 401(k) plan and follow-up IRA rollover affect the decision to convert a traditional Individual Retirement Account to a Roth IRA?

The fortunate answer is that the timing of the rollover is irrelevant to the tax cost of converting a pre-existing IRA to a Roth IRA.

Let’s say the IRA is worth $200,000 and the 401(k) is worth $1,000,000. By rolling over the $1,000,000 to a traditional IRA, that $1,000,000 is excluded from your Adjusted Gross Income and from your taxable income. So when you add the $100,000 IRA balance to your other 2010 income to figure your tax cost, the $1,000,000 doesn’t appear anywhere or affect any of your tax calculations.

And the same is true if you elect to have the $200,000 taxed in 2011 and 2012, $100,000 each year. The $1,000,000 rollover disappears from those tax calculations as well.

And the same is true whether the 401(k) rollover occurs before or after the Roth IRA conversion. Or even if the Roth IRA conversion happens during the up-to-60-day period between when the 401(k) plan distributes the $1,000,000 and you roll it into your IRA.

Finally, once the dust settles on the rollover, you have th rest of the year to decide if you want to Rothificate some of it in addition to the original $200,000. At a greater tax cost, of course.

I hope that answers the question.

Roth Accounts for Federal Employees?

Riddle: What does a Roth 401(k) account have to do with smoking cigarettes?
Answer: Read on.

I am a big fan of Roth savings, as expressed in a number of prior posts; particularly for those who would like to save more in their tax-favored retirement plans, but are prevented from doing so because of limitations in the Tax Code. So Roth 401(k) accounts, potentially available since 2006, have been a great recent development, since they carry no income-related restrictions. But Roth 401(k) accounts are only an option if your employer chooses to make them available.

What about federal employees? Federal employees are covered by the Thrift Savings Plan, a 401(k)-like retirement savings plan. Unfortunately, there is no provision for Roth accounts in the Thrift Savings Plan, so federal employees are out of luck.

But that may change soon. The Board governing the Thrift Savings Plan has this week endorsed a proposal to add a Roth option to the TSP. That’s the good news. Now here’s the bad news: actually adding such a feature requires legislation. The House of Representatives passed a bill adding Roth accounts to the TSP, but the Senate and President also have to act.

Now back to the riddle: What does Roth saving have to do with cigarette smoking? In the real world, nothing. In Bizarro congressional world, apparently they are deeply related in ways the rest of us can’t begin to fathom. The provision for adding a Roth savings option to the TSP is included in a bill to give the FDA authority to regulate tobacco. So whether federal employees get a favorable retirement saving opportunity may hinge on how your senator feels about giving the FDA the power to regulate tobacco.

Federal employees, join the rest of us. We in private industry only get Roth opportunities if our employers choose to add it to our 401(k) plans; you only get them if your senator believes in federal regulation of tobacco.

Your Teenager’s Retirement Saving

Teenagers. Ya gotta love ‘em. It’s like having your own personal Linda Blair around the house. As long as you’ve got to get yourself and your kids through the high maintenance teenage years, you might as well impart some good habits along the way. Like acceptable hygiene. And retirement saving.

When they get that first summer or after-school job, they are going to have a lot of discretionary income—a lot compared to what they need and are used to. So there’s no better time than the teenage years for them to begin the saving habit—setting aside a portion of their working income in a savings bucket of one kind or another. Saving is like playing baseball or doing crossword puzzles or lifting weights or playing guitar—the more you do it, the better you get at it. It becomes second nature. So there’s no better time for a person to learn how to save than when she has her first taste of discretionary compensation.

You might even encourage your kids’ saving habit by subsidizing it. Maybe give them a dollar for every two they put away in a savings bucket, so they can continue to enjoy some of the consumption benefits of their hard-earned income. It’ll be like your own family matching contribution.

So what’s the best kind of savings bucket for a teenager? That’s a no-brainer. It’s the Roth IRA! Teenagers don’t have much income (except for Miley Cyrus) so they usually meet the qualification rules for contributing to a Roth IRA, as described in February 4’s post. And for a teenager, the tax cost of foregoing a deduction (had they instead contributed to a traditional IRA) is very small; maybe even zero. Then the dollars they put aside—and every dollar of investment earnings for the next 70 or 80 years—is totally tax-free. What a deal!

Now don’t you wish you were a teenager again so that you could start your own Roth IRA? When I was a teenager there was no such thing as IRA's or Roth IRA's. Or electricity. Or the wheel.

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.

2009 vs. 2010 Roth IRA Conversion

Let me share with you a real-life issue presented by a reader: He has a traditional IRA which he would like to convert to a Roth IRA. His 2009 modified Adjusted Gross Income is under $100,000 so he can do it this year. Or he can do it in 2010, regardless of his AGI. Remember, if he does the Roth conversion in 2010, that’s the year of the IRS’s Great Roth Sales Event. You have the option of spreading the taxable income from a 2010 conversion over two years, 2011 and 2012, as described in February 28’s post. So which is the better option?

Here are the considerations we came up with:
• There’s always the possibility that Congress changes the law and eliminates or restricts Roth conversions beginning in 2010. So that factor favors the 2009 conversion. Grab it while you can.
• Some people harbor the fear that some time in the future a deficit-strapped Congress will renege and make Roth IRA distributions (or part of them) taxable. I personally don’t think that’s very likely. But, hey, you never know. But that gets to whether any Roth conversion is wise, not when to do it. So, that’s a push.
• What are your tax brackets in 2009, 2011, and 2011? A low tax bracket year is a factor favoring the Roth conversion in that year.
• If you expect to have high income in 2011 or 2012, you can’t ignore the possibility of a tax rate increase, as has been proposed. And if you are thinking about converting a large IRA, the conversion itself will make you a high-income person for that year.
• If you expect your IRA to grow with investment earnings, that growth favors doing the Roth conversion now. Waiting nine months until 2010 will increase the amount of income that’s taxed in order to get a given portion of your IRA converted.
• The IRS’s Great Roth Sales Event in 2010 favors waiting until 2010. You get the benefit of a bit of tax deferral. How much is that worth? I ballpark it as making a Great Roth Sales Event conversion about 7.5% cheaper than a regular 2009 conversion, assuming the same tax brackets in 2009 as 2011 and 2012. Here’s where I get that number: In 2010, the IRS lets you defer half the taxable income for one year, and half for two years. That’s an average of 1.5 years’ deferral. Add another year of tax payment deferral you get by waiting for 2009 to turn into 2010. If you invest the expected tax cost in a tax-exempt money market fund, you might project 3% per year return. So that works out to a 7.5% discount on the tax.
• How does that 7.5% discount compare to your projected growth in the IRA over the next nine months? If you’ve got your IRA invested in fixed income investments, that factor favors waiting until 2010, since your IRA is not likely to grow by that amount in nine months. On the other hand, if your IRA is invested in equities, it’s been hammered pretty hard over the last 17 months. Is it time for the turnaround we’re all dreaming about? Ask yourself, are you feeling lucky?
• Here’s an important bit of advice. Whenever you do the Roth conversion, whether it’s March 2009 or during the IRS’s 2010 Great Roth Sales Event, estimate your tax cost based on the market value of the converted IRA and invest that conservatively while you wait for tax payment day to roll around. Particularly if you’re taking advantage of the 2010 Sale. Payment may be delayed, but the tax will soon be due. You don’t want to get whipsawed by investing the IRS’s interest-free loan in equities, which then go down in value before tax bill date arrives.
• There might be another factor that comes into play. If you delay the conversion until 2010, how will you be investing the money that's outside your IRA for the next nine months? The arithmetic three bullet points ago assumed it’s invested in a tax-exempt money market. But what if you’ve got it invested in equities, or in the same mix of equities and fixed income as your IRA? (The caution urged in the last bullet point gets triggered by the Roth conversion, but doesn’t necessarily apply while you’re waiting nine months to convert.) That tends to increase the breakeven rate of growth at which the 2009 conversion beats the 2010 conversion.

So which is better, 2009 conversion or 2010 Great Roth Sales Event conversion? Bottom line, nobody knows. If you can think of a factor I’ve left out, please post a comment or send me an email. TheTwoLeggedStool@gmail.com.

Roth IRA's vs. Required Minimum Distributions

In the last couple of posts, I have talked about traditional tax-favored retirement accounts and how the Required Minimum Distribution rules dictate the gradual expiration of their valuable tax-exemption. But Roth IRA’s are different. Required Minimum Distributions don’t have to begin until after your death; or, more accurately, after the death of you and your spouse. So with Roth IRA’s, the end of tax-exemption is dictated by your need for spending money rather than any RMD rules, at least during your lifetime.

This suggests another opportunity for Spigot Planning—the clever choice of which savings bucket you tap first to meet your living expenses.

As an example, consider Jerry and George from yesterday’s post; but let's change the situation. They each still have $1,000,000, but now it’s split equally between a Roth IRA and a taxable investment account. George holds to his naïve approach of taking his spending proportionately between his two accounts. Jerry—clever fellow—first depletes his taxable investment account before tapping into his Roth IRA, thus preserving the Roth IRA’s tax exemption for as long as feasible. Using reasonable assumptions, George projects that he will be able to spend $56,584, increased each year for inflation, before depleting his wealth at age 100. Jerry projects he will be able to spend $59,231 per year, a 4.7% increase. Nice work, Jerry!

Notice how much more meaningful the benefit from Spigot Planning compared to yesterday’s example. That’s because Roth IRA’s have no lifetime Required Minimum Distributions, so there’s more opportunity to benefit from delaying distributions from your tax-favored retirement account.

More to come on Spigot Planning.

Taxation of Nonqualified Roth Distributions

In yesterday’s post, I described the two requirements you have to meet in order to avoid all tax on all distributions from your Roth accounts, both Roth IRA’s and Roth 401(k) or 403(b) accounts. But what if you fail one or both of the requirements? Well, the IRS must really love Roth accounts, because the scheme for taxing these distributions (called “nonqualified Roth distributions”) is quite favorable.

First, keep in mind that you paid tax on your original contributions, so you get to recover these tax-free. Makes sense. Now here’s the good part: You get to recover your contributions tax-free before you have to start paying tax on the previously untaxed investment earnings within the account. What a deal! This is totally different from the scheme for taxing distributions from traditional IRA’s with non-deductible contributions (as explained in February 15’s post).

Here’s an example. Let’s say a few years ago you converted a $50,000 traditional IRA to a Roth IRA, and now, with investment earnings, it’s worth $75,000. If you take a distribution of up to $50,000, the distribution is income tax-free even if you don’t meet the two requirements described in yesterday’s post. Only when your aggregate distributions exceed $50,000 do you start to pay tax on the remaining $25,000. And if you can just hold off dipping into the remaining $25,000 until after you meet the two requirements described in yesterday’s post, you can avoid tax on that as well. Shazam!

There’s one trap to be aware of, and it relates to the 10% penalty on distributions before age 59-1/2. If your distribution comes from a Roth IRA, and that Roth IRA was created by conversion from a traditional IRA, and you don’t qualify for any exception to the 10% penalty (catalogued in February 19's post), and the distribution occurs within the five-year period beginning with the year of the conversion, then you’ll have to pay a 10% penalty tax on the distribution even if it is not subject to regular income tax. Is this just too complicated? You bet. Am I making this stuff up? No. Honest.

Another thing to be aware of is that a rollover avoids tax. If your distribution from a Roth IRA is immediately rolled over to another Roth IRA, then you avoid all tax on that distribution. I’ll describe rollover rules in a future post.

This is enough for today.

Tax-Free Roth Distributions

One of the beauties of Roth savings is that distributions can be totally tax-free. All those years’ worth of investment earnings can escape the ravages of income taxation!

Note the use of the word “can.” As with all things tax-related, there are requirements to be met to get this valuable benefit, and that’s the subject of today’s post. For a distribution from a Roth IRA or Roth 401(k) account or Roth 403(b) account to be totally tax-free, the distribution has to meet two requirements: (i) It has to follow a triggering event; and (ii) it has to meet the five-year requirement.

Triggering Event. Only four triggering events qualify. Any one will do. Here they are:
1. Age 59-1/2. This is the most common situation. Any distribution after you reach age 59-1/2 meets this first requirement. Who came up with that half-birthday concept?
2. Death. Any distribution to your beneficiary following your death meets this requirement.
3. Disability. Any distribution attributable to your disability also meets this requirement. The Tax Code uses a rather strict definition of “disability.”
4. First-time home buyer. A distribution of up to $10,000 to enable you, your spouse, a child or a grandchild to purchase a first home qualifies. This triggering event applies to Roth IRA’s but not Roth 401(k)’s or 403(b)’s.

Five-Year Requirement. Okay. Let’s say you’ve met the first requirement, say because you’re age 65. Not so fast, Kemosabe. Your Roth account also has to meet a five-year holding period requirement. The distribution has to occur after the following date:

Roth IRA: After the end of the five-year period beginning with the first day of the year for which you made your first Roth IRA contribution, or during which you first converted a traditional IRA to a Roth IRA. Once you’ve met this holding period, you’ve passed the test for all time and for all of your Roth IRAs. This particular clock only has to run once, and then you’re good to go.
Roth 401(k) or Roth 403(b): After the end of the five-year period beginning with the first day of the year in which you made your first Roth contribution to the 401(k) plan or 403(b) plan. Since these types of accounts first began in 2006, nobody will meet this requirement until January 1, 2011 at the earliest. Generally, unlike Roth IRA’s, a separate five-year cock has to run for each 401(k) plan or 403(b) plan in which you participate.

Here’s a good idea, particularly for people age 54 or older: Because of the five-year requirement, if you think there might be meaningful Roth savings in your future, it’s a good idea to make a Roth contribution as soon as it’s allowed, just to start the running of the five-year clock. A small token Roth contribution will do. Or converting a token amount from an existing traditional IRA will also do; which is just another reason to look forward to 2010, as explained in February 28’s post.

What if you fail one of the two requirements? Take heart. All is not lost! But that subject will have to wait for tomorrow’s post.

An Unanswered Question About Roth IRA’s

Here is today’s question: What is the sound of one hand clapping?

No, wait. That’s not the question. The question is this: Starting in 2010, are Roth IRA contributions limited to those with low Adjusted Gross Income (AGI, for short)?

You may recall from February 10’s post that if you have earned income you can make a contribution of up to $5,000 to a Roth IRA ($6,000 if you’ve reached age 50), but only if your AGI does not exceed specified limits ($105,000 if you’re single; $166,000 if married filing jointly; with a $10,000 to $15,000 phase-out range where life gets complicated).

But Congress changed the law so that starting in 2010, anyone, regardless of their AGI, can convert a traditional IRA to a Roth IRA. So if you want to make a $5,000 Roth IRA contribution, but your AGI exceeds the above-mentioned limits, what’s to stop you from contributing your $5,000 (or $6,000) to a traditional IRA, and then immediately turning around and converting that to a Roth IRA? As far as I know, nothing.

So although Congress did not expressly do away with AGI limits on Roth IRA contributions, did they inadvertently do so by opening a back door? I think so. I invite any reader who has some wisdom on this question to post a comment or send me an email. Even better if you can cite some authority.

The Politics of Roth

This daily blog is usually dedicated to personal retirement planning. But occasionally I feel motivated to digress into public policy. Today is one of those days. It’s not like it’s my birthday or anything. But sometimes it’s just nice to ramble. The weather’s nice. It’s March, so it’s almost spring. Today I’ll digress.

I’ve devoted a number of posts to the pros and cons of saving on a Roth basis instead of a traditional pre-tax basis. I’m trying to help you answer the question, “What’s in my long-term best interest?” But why has Congress offered us all these opportunities? Roth IRA’s. Roth 401(k)’s. Roth conversions. 2010 Roth sale.

Think of it as the stealth triumph of Steve Forbes. Remember him? He lost the Republican primaries in 1996 and 2000. Big time. He campaigned on the misguided platform of a flat tax on all of your compensation income, but excluding any tax on income from your investments. Imagine if his tax policy had carried the day. People wealthy enough not to have to work, who live off their interest, dividends and capital, would not share in the country’s tax burden. I don’t know about the economics of that kind of system, but the politics is just plain nutty.

But that’s what Roth saving is all about. You pay tax when you earn the compensation by not getting a deduction as you would, say, for a pre-tax contribution to your traditional 401(k) plan. And then you never again pay tax on the interest, dividends and capital gains within the Roth account.

So it turns out Steve Forbes has won, but only to some extent. Roth opportunities are limited in amount. A wealthy person can’t just Roth-ificate all his investments; just the part that’s found its way into a tax-favored retirement account. And those parts are limited by law (as described in February 4’s post). But for most Americans, that’s enough. Few of us can afford to save more than the amounts the Tax Code allows us to contribute to our IRA’s, 401(k)’s, and the like. For all but the wealthiest, these accounts can (and do) contain all of our savings. (Well, there’s also our houses, but most capital gain on that is tax-free too.)

How did we get to this point? The Bush administration was, like Forbes, enamored of the concept of excluding capital-based income from taxation. And for a while Bush had the requisite sway with Congress. So he achieved a few steps in that direction: Expansion of Roth opportunities; extremely low tax rates on dividends and capital gains. For years he promoted (unsuccessfully) further expansion of the concept, trying to create Lifetime Savings Accounts, which would have been Roth-like accounts that could be used for any purpose, not just retirement. Bush even feinted toward permanently abolishing all traditional pre-tax retirement accounts (all of them!!!), a recommendation made by his commission to reform the income tax system.

How was Bush so successful with Congress where Forbes fell on his face? It probably didn’t hurt that Roth savings—particularly Roth conversions of large pre-existing traditional IRA’s—generate lots of near-term revenue at the expense of future revenue, a subtle form of inter-generational theft. Roth opportunities help Congress pretend it’s balancing the budget by only looking at 10-year projections, while the real revenue losses don’t hit until many years down the road when the growing army of Roth retirees stop sharing in the tax cost of running the show.

Well, that ramble was fun. Tomorrow I’ll go back to my usual posture: “To hell with the next generation. What’s in it for me?”

2010 Roth Conversion

The IRS is having a sale!

Starting in 2010, and in every year after that, anyone willing to pay the income tax cost may convert all or part of their traditional pre-tax IRA’s to a Roth IRA. You will no longer be precluded from doing this if your modified Adjusted Gross Income exceeds $100,000 as is currently the case. And to kick off this new opportunity, they’re having a one-time sale on Roth-ification. A grand opening sale, if you will.

Here’s the deal. Let’s say you have a $500,000 traditional IRA, and you’d like to convert $200,000 of it to a Roth IRA. If you do that in 2009 or 2011 or later, the normal rules apply; normally, you would add that $200,000 to your taxable income in the year of the conversion and pay tax on it at your tax bracket for that year. More likely, with such a large amount of additional income you would end up crossing tax brackets and paying tax at some blended rate.

But in 2010, you can take advantage of the IRS’s one-time sale. Instead of adding $200,000 to your 2010 income, you have the option of splitting it in half and adding half to your 2011 income and half to your 2012 income.

What a deal! There’s two potential benefits to be gained here. First, there’s delay. You get to delay tax payment, which is always worth something. You can set aside the tax dollars you’ll owe, put them in a money market fund, and collect the interest for a while. The IRS is in effect giving you an interest-free loan for a year or two.

But wait. There’s more. Second, by spreading the taxable income—$200,000 in our example—over two years, you might reduce the portion of it that’s kicked up into a higher tax bracket and thereby actually reduce your overall tax bill. It’s Christmas in July! (Or April, actually.)

What about state tax? That depends on how your state figures its income tax. Many states, like New York and Georgia for instance, start their tax calculations with your federal Adjusted Gross Income and then fiddle around from there. In these states you’ll end up getting a similar state tax break, because your $200,000 will be split between your 2011 and 2012 federal Adjusted Gross Income. Unless your state legislature decides this particular situation ought to be handled differently.

So if you’ve concluded that Roth-ification of all or part of your IRA is a good idea for you, then doing it in 2010 might indeed be a very good idea.

Act now (actually next year). This offer won’t be repeated. Operators are standing by.

Hidden Tax Brackets

Yesterday’s post described the difficulty of figuring your tax bracket. It mentioned the concept of hidden tax brackets—places where the Tax Code causes you to lose a tax goody because of additional income, resulting in an effective marginal tax rate that’s way higher than what the published tables would have you believe. I thought it would be informative to provide an example.

Informative, yes. Useful, no. Because the intricacies of how these hidden brackets work make it difficult to predict them or plan around them. With that disclaimer, read on.

Example. George is single. He earns $55,000 in 2009 working for the New York Yankees, where he’s covered by a pension plan. George contributes $5,000 to a traditional individual retirement account. And that $5,000 is deductible, as explained in February 14’s post. George’s federal income tax works out to $6,350, after taking into account his IRA deduction, personal exemption and standard deduction. And he’s solidly ensconced in the 25% federal tax bracket.

Lucky George! The Yankees pay him an unexpected year-end bonus of $10,000! George guesses he’ll owe $2,500 federal tax on his year-end bonus because he’s in the 25% bracket. Wrong as usual, George! George is gob-smacked by a nasty hidden tax bracket. The extra $10,000 of income causes him to lose his $5,000 IRA deduction (again, see February 14’s post). Which in turn causes him to pay tax on $15,000 of income rather than $10,000. At his nominal 25% tax bracket, that’s $3,750 of tax. So his actual hidden tax bracket on the $10,000 bonus is 37.5%.

That’s a pretty high tax rate for a poor schlep like George, who’s not even the CEO of a failing bank.

A Word or Two About Tax Rates

Yesterday’s post and a number of prior posts somewhat facilely refer to your tax bracket—both current and future. Just what do I mean by tax bracket? It's time to enter that heart of darkness.

When you are trying to decide between two retirement planning strategies—how much to save, how much to spend, to Roth or not to Roth, which savings bucket to spend first, in which savings bucket to house your stocks, etc.—it often becomes necessary to guess at, and compare, your marginal tax brackets. “Marginal” means the tax bracket affecting your top dollar of income, rather than the average tax rate on all of your income. They’re not the same because we have a progressive tax system.

(A brief aside: “Progressive” means the tax rate gets higher as your income increases, as with the federal income tax. “Regressive” means the rate gets lower as your income increases, as with the Social Security tax [6.2% on the first $106,800 of compensation, 0% on the rest]. But these words are really loaded. “Progressive” sounds so modern, advanced and forward-thinking. “Regressive” sounds like you’re a troglodyte. But no value judgments are intended. The words just describe how the rates vary with the thing that's taxed, income in this case.)

Example. Mary is single and earns $150,000 as a TV news producer. She uses the standard deduction, and claims just herself as a personal exemption. Her 2009 federal income tax totals $33,102, so her overall average tax rate is 22%. But her marginal tax bracket increases with each tranche of income. The first slice of $9,350 of income is taxed at 0% (representing her personal exemption and standard deduction). The next $8,350 is taxed at 10%; then $25,600 at 15%; $48,300 at 25%; and the balance ($58,400) at 28%. Mary’s marginal tax bracket is 28%. So any moves she makes—to reduce or increase her taxed income—either saves or increases her tax by 28%. Sort of. Read on.

Often things are not so simple. Here are some of the complications you’ll run into as you try to figure your marginal tax rate.
• Crossing brackets. A big move might cause you to shift—up or down—from one bracket to the next. So some of your income is at one marginal tax bracket and some at a different one. For example, converting a large traditional IRA to a Roth IRA can easily cause you to straddle two brackets.
• Alternative Minimum Tax. If you have large deductions that are classified as “tax preferences” (such as state and local taxes) then you might be paying Alternative Minimum Taxes, in which case your marginal tax bracket becomes 26% or 28% regardless of what the regular tax rate tables say.
• State income tax. If your state has an income tax, your marginal state tax rate should be added to your marginal federal tax rate to figure your effective tax bracket. In our example, Mary lives in Minnesota, and figures her marginal state tax rate is 7.85%, making her total marginal tax bracket 35.85%.
• Effect of state tax on federal income tax. If Mary itemizes her deductions, then her state tax reduces her federal tax. So her effective marginal tax bracket would then be 33.65%. Unless she’s paying Alternative Minimum Tax. Oy.
• Hidden tax brackets. The federal tax code is just full of hidden tax brackets. Various tax deductions , credits and other such goodies are available only to those with lower income, and then get phased out for those with higher income. If you are within these phase-out ranges—which vary from one goodie to the next—then you are actually subject to a higher hidden tax bracket, as you lose the benefit of a deduction or credit. Gotcha!
• Capital gains. Some income—notably long-term capital gain—is subject to favorable tax treatment, resulting in a lower tax bracket for that type of income.

The message here is that it’s massively complex just figuring what tax bracket you’re in today, even after you’ve completed your tax return. And so what about projecting your bracket 20 years into the future? Forget about precision. Just take your best shot at an educated guess.

The horror; the horror!

How Age and Tax Rate Affect the Roth Decision

In a few recent posts, I have talked about the long-term benefit of Roth-ifying your retirement funds. But is it a good idea for everyone? Certainly not. It’s hard to assess all the factors and uncertainties that go into the decision. But probably the two most critical factors are Time and Tax Rate: How many years until your retirement? How large will your future income tax rate be compared to your current tax rate?

How do these factors impact the Roth decision? Here’s a little thought experiment. Picture Riley. He’s got $10,000 in a traditional IRA and $10,000 in an ordinary taxable investment account. Should he spend some of the dollars in his taxable account to convert the $10,000 IRA into a $10,000 Roth IRA? That depends on how many years Riley has until he retires and his future tax rate. The chart below shows the benefit (or detriment) of the Roth conversion, as measured by the increase (or decrease) in Riley’s future annual after-tax retirement spending generated by his $20,000.

Riley is currently—during his working years—in the 30% tax bracket. The projections below indicate that he might still enjoy some advantage from Roth-ifying his IRA, although a shrinking one, if he expects to be in a lower tax bracket during his retirement years.

Here are the assumptions that went into the figures in the chart.
• Riley’s current tax rate is 30%, so it costs $3,000 to convert his IRA to a Roth.
• Riley is in the 30% tax bracket during his working years.
• Riley’s IRA (traditional or Roth) earns 6% per year during his working years.
• Riley’s taxable account earns 6% during his working years, but keeps only 4.8% after tax.
• Riley spends his two accounts by amortizing them over a 25-year retirement period.
• Riley’s IRA (traditional or Roth) earns 5% per year during his retirement years (when his investments get more conservative).
• Riley’s taxable account earns a fraction of that 5% after tax. To estimate that percentage, I used the following formula:
5% - (2/3) x Tax Rate x 5%
See February 3’s post for the reasons behind the 2/3 fudge factor.
• Riley's assumed number of remaining working years are shown in the top row of the chart below.
• Riley's assumed tax rate during his retirement years are shown in the left-hand column of the chart below.

Tax-Free Conversion of Non-Deductible IRA Contributions to Roth IRA

In yesterday’s post, I described how you figure the tax cost of converting a traditional IRA to a Roth IRA when you’ve got some non-deductible contributions in the traditional IRA. I used an example of an $80,000 traditional IRA with $10,000 of non-deductible contributions.

Wouldn’t it be great if you could just convert the $10,000 of non-deductible contributions to a Roth IRA, and pay no tax for the privilege of doing so? Well, maybe you can. Here’s a little trick that might work for you. Read on.

If your employer maintains a tax-favored retirement plan, such as a 401(k) plan or a 403(b) plan, and that plan accepts rollovers from IRAs, then before you do your Roth conversion, you roll over the taxable portion of your traditional IRA to your employer’s plan, $70,000 in our example. In fact, you’re not even allowed to rollover your $10,000 of non-deductible IRA contributions to an employer plan. What does that leave you with? A $10,000 traditional IRA, all of which is considered your own non-deductible contributions. You can convert the whole thing to a Roth IRA without paying any income tax for the privilege of doing so! What a country!

Here’s a couple of caveats about the foregoing trick:
• It only works if you qualify for a Roth IRA conversion, i.e., $100,000 or less Adjusted Gross Income in 2009. Or wait until 2010, when the AGI limit goes away.
• It only works if your employer’s plan accepts rollovers from IRAs. Some do, some don't.
• You end up with most of your IRA money in your employer’s plan, subject to its investment and distribution restrictions, as described in February 11’s post and February 18’s post.
• While your retirement money is in your employer’s plan, you won’t be able to Roth-ificate it until you are able to roll it over back into an IRA.

But if you can get over these hurdles, you end up moving your non-deductible IRA contributions into a better savings bucket. Take that, IRS!

Roth Conversion of Non-Deductible IRAs

In a number of posts, I have plugged the tax benefits of Roth IRAs. And in February 15’s post, I extolled the virtues of a non-deductible IRA when a deduction is unavailable. Today I amalgamate them. What if you want to convert a non-deductible IRA to a Roth IRA?

First, of course, you have to determine if you’re allowed to. February 10’s post pointed out that in 2009, you can do this only if your Adjusted Gross Income is $100,000 or less. But in 2010 and thereafter, that requirement disappears. Poof! It’s gone! And of course you generally have to pay income tax on the amount converted.

But if you’ve made non-deductible contributions to your traditional IRA, you don’t have to pay income tax on that portion. You paid tax going in, so you don’t have to pay it again. No double tax. Here’s an example. Let’s say your only IRA is worth $80,000 and over the years your aggregate non-deductible contributions have totaled $10,000. In tax jargon, $10,000 is your tax basis in the IRA. (You can find this number on your most recently filed Form 8606.) If you convert the entire IRA to a Roth IRA, you’ll have to pay tax on $70,000 (= $80,000 - $10,000).

But what if you convert only a portion of your IRA to a Roth IRA, e.g., because you can’t afford to pay tax on the whole thing? Then you recover a pro-rata portion of your tax basis. For example, if you convert $20,000 of your $80,000 IRA to a Roth IRA, that’s 25% of the total. So you recover $2,500 of your $10,000 tax basis, and pay tax on $17,500 (=$20,000 - $2,500). You then have $7,500 of basis left in your traditional IRA to recover tax-free in later years.

What if you’ve got more than one traditional IRA? In figuring the portion that’s tax-free, the IRS makes you aggregate all your traditional IRAs (but not your employer plans or Roth IRAs) and all your non-deductible contributions. So it doesn’t help to try to isolate your non-deductible contributions in one small IRA. The IRS is on to your little tricks!

But tomorrow I’ll describe a little trick that can work. Meet you back here about the same time tomorrow.

Roth Opportunities

In yesterday’s post and in January 15’s post I discussed how Roth retirement savings can be a valuable option for people who are contributing the maximum allowable amount to their tax-favored retirement plans, or who want to shift more savings from a taxable investment bucket to a tax-favored retirement plan. “Okay,” you say, “sounds right to me. I’m doing it.” Not so fast, Kowalski. Unfortunately, the feds have erected barriers to Roth-ification. Here’s a brief rundown of those barriers.

(Here’s a fun fact to know and tell. Roth retirement accounts are named after the late Senator William V. Roth, Jr. of Delaware, who championed their creation. “Roth IRA” is the first known instance of an individual’s name actually appearing in the Internal Revenue Code. And thus the late Senator Roth has achieved immortality. But as Woody Allen said, I’d rather achieve immortality by not dying.)

Roth opportunities, like detergent, come in three sizes: small, medium and large. And the barriers differ for the three.

Small. You can make your annual Individual Retirement Account contribution to a Roth IRA instead of a traditional pre-tax IRA.
• The maximum contribution is $5,000 (plus cost-of-living increases beginning 2010).
• Plus an additional $1,000 if you will have reached age 50 by the end of the year (plus cost of living adjustment beginning 2010).
• Also may not exceed your earned income (e.g., salary or self-employment income, but not interest or dividends).
• Annual Roth IRA contributions are not allowed if your Adjusted Gross Income for the year (2009) exceeds the following limits. There’s a small range ($10,000 - $15,000) of Adjusted Gross Income above these limits where a Roth IRA contribution is reduced rather than prohibited:
o Married, filing jointly: $166,000
o Single: $105,000
o Married, filing separately: $0

Medium. You can make your elective deferral to your employer’s 401(k) plan or 403(b) plan on a Roth basis instead of a traditional pre-tax basis.
• The maximum contribution is $16,500 (plus cost of living adjustment beginning 2010).
• Plus an additional $5,500 if you will have reached age 50 by the end of the year (plus cost of living adjustment beginning 2010).
• Unlike Roth IRA contributions, with Roth 401(k) contributions there is no cap on your Adjusted Gross Income.
• But there is a potential barrier: This opportunity only applies if your employer’s plan offers it.

Large. You can convert all or part of an existing traditional IRA to a Roth IRA, regardless of its size.
• There is no limit on the amount in the IRA that can be converted.
• You must pay income tax on the amount converted.
• In 2009, this opportunity is restricted to those with Adjusted Gross Income of $100,000 or less (and is not available if you are married, but filing separately).
• “Adjusted Gross Income” is specially defined to exclude income realized from the Roth conversion itself and from required minimum distributions for the year.
• BIG NEWS: The Adjusted Gross Income limitation disappears in 2010, and this opportunity will be available to all with traditional IRAs!