Three big myths about Roth conversions

November 25, 2010

Some experts are anticipating a “race” at the end of year as individuals rush to do Roth conversions under the new rules enacted for 2010. However, many people rushing to do Roth conversions may be basing their decision on various bits of misinformation and common myths. In this article, I’ll dispel a few common myths and try to clear up some misinformation. Nobody but you can decide whether a Roth conversion makes sense for you, but having accurate information will help you make the best decision for yourself.

(Quick background: In a Traditional IRA, you get a tax deduction when you contribute to the account, but pay taxes later when the money is withdrawn. Roth accounts are the opposite, no deduction is allowed when the money goes in but you can later take the money out, with earnings, without paying any taxes. This offers several advantages, the main one being that if you expect to be paying taxes at a higher rate later, a Roth allows you to pay taxes at your current lower rate and not later at the higher rate. Many individuals wanting to take advantage of the tax benefits related to Roth accounts have previously been unable to open these accounts due to the income limitations that were in place. 2010 is the first year that conversions from Traditional IRA accounts to Roth IRA accounts is allowed for individuals with Modified AGIs in excess of $100k.)

  • Myth #1: 2010 is the ONLY year individuals with income over $100k will be able to do Roth conversions. Not at all, 2010 is simply the FIRST year individuals with income over $100k are able to convert. The only thing unique about 2010 is that taxpayers who convert in 2010 may elect to be taxed on half the conversion amount in 2011, and half in 2012. Given the uncertainty surrounding tax rates in the next few years, and the likely possibility that at least some will be rising, this isn’t a good deal for most people. Of course, taxpayers who’d rather not pay the tax until 2011 or 2012 have the option to simply wait until 2011 or 2012, when presumably they’ll have a better handle on the tax implications, and make the conversion in those years.
  • Myth #2: In the long-run, you’re better off with a Roth because you can take the money out tax-free. The “short-run” or “long-run” has nothing to do with this calculation. This myth feeds on the fact most of us don’t think about algebraic identities in our daily lives. When you boil it down, this argument basically hinges on the idea that changing the order of multiplication will somehow change the outcome of a problem. It’s simply not true. 6 x 9 = 9 x 6 and this is true for any two pairs of numbers.

The only reason to put money in a Roth is you expect to be hit with a higher tax rate later than what you’re subject to currently. For individuals who are fully employed in their peak earning years (generally about age 40 to 60), this is a highly dubious assumption — unless you’re counting on a pension that exceeds your salary. Even considering the possibility of future tax increases, you have to discount for the fact retirees are the largest voting bloc and have historically been able to carve out considerable tax advantages for themselves in the tax code.

[A little more explanation and an example is at the end of this article.]

  • Myth #3: Roth conversions are irreversible. Actually, the flexibility regarding Roth conversions is one good reason for considering conversion. If you convert Traditional IRA money into a Roth, you have until the tax filing deadline for the tax year to undo the conversion. So, theoretically, you could convert on Jan 1 2010 and–by filing an extension for your 2010 tax return–undo the conversion (aka “recharacterize”) all the way up to Oct 15 of 2011.

This actually presents an interesting opportunity if you’re willing to do a little paperwork. You can convert your money into multiple different Roth accounts. Wait until you’ve almost reached the filing deadline, and then recharacterize any accounts that have lost money.

Why only the accounts that have lost money? Well, you’re paying tax on the full amount converted, and if the account has lost money, you’re paying tax on money that’s already been lost. On the flip side, the earnings in accounts that have made money represent income that won’t be taxed because the money wasn’t there when the account was converted. Those earnings will NEVER be taxed!

There are some good reasons to consider doing a Roth conversion. However, there are also many bad reasons being promoted by people who don’t know any better, or who simply want to earn a commission off of you opening another account. Before considering any significant financial transaction, always run it by a tax advisor who can look at your specific situation and let you know any potential pitfalls.

[Additional explanation/example for myth #2: How much money you’ll have left from a retirement account after taxes is a function of 3 simple variables: how much money you start with, your effective rate of return, and the tax rate you pay on the money. How much you start with and your rate of return are the same regardless of whether your money is in a Traditional or Roth account. Only the tax rate you pay can change. And whether the rate is paid when the money goes in or out makes no difference. It’s a result of the basic algebraic identity a*b*c = a*c*b, but here’s an example:

Start w/ $100. Pay 20% tax now, leaving you with $80. Invest $80 in a Roth where it grows w/ no taxes, resulting in the money growing to 400% of its original value at the time you withdraw the money. You withdraw $320 (80×4). Now start w/ the same $100. Invest in a Trad IRA and get the same rate of return. You have $400. When you withdraw the money, you pay a 20% tax ($80), leaving you with $320. It makes no difference whether you pay the tax at the beginning or end.

Since your initial investment doesn’t change, and the rate of return once the money is within a tax-sheltered account doesn’t change, then the only thing that matters is the tax rate. If you expect your rate will be higher later, pay the tax now. If you expect your rate will be lower later, pay the tax later. It’s really that simple. Time period and rates of returns don’t matter if you’re trying to figure what leaves you the most money when the money is withdrawn.]