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Doing the Roth IRA Conversion Arithmetic

Personal_Finance / Pensions & Retirement Apr 10, 2012 - 12:15 PM GMT

By: Terry_Coxon

Terry Coxon, Casey Research writes: It's clear to me, even though it may not be clear to you, that unless there is something very unusual about your situation, if you have a traditional IRA, you should pay the tax now and convert it to a Roth IRA. Not just maybe, but definitely. Not just for a small advantage but for a big one. If you don't convert today, you'll ultimately surrender much more to the tax collector. You'll be throwing money away. And you'll keep throwing it away. It's a result neither of us wants.

Your IRA is an object in motion, with money going in and out of it and investments turning over inside of it. It lives not just on your brokerage statement but across the years of your calendar as well. That's why the Roth conversion question can seem so tangled. Because of the time dimension, deciding whether to convert isn't as simple as deciding whether to replace one stock with another. But there is, as I'll try to show, a way to look at the question that cuts through the complexity.

Comparisons

With a traditional IRA, you are allowed to contribute $5,000 per year of employment income (or $6,000 if you are 51 or older), and, if your income isn't too high, you receive a tax deduction for the contribution. Earnings inside the IRA accumulate and compound free of current tax. Later, when you withdraw the money, it comes to you as taxable income (except to the extent of any contributions that weren't tax deductible when made, which come out tax free).

With a Roth IRA, if your income isn't too high, you may contribute up to the same $5,000 or $6,000 per year, but none of it is tax deductible. Just as with a traditional IRA, earnings inside the Roth accumulate and compound free of current tax. When the money comes out, assuming you are at least 59.5 years old and the IRA is at least five years old, the money goes tax free straight to your pocket.

Whether traditional or Roth, any IRA's power to make you richer comes from tax-deferred compounding. Consider a simple example that compares an ordinary, taxable savings account with a traditional IRA. Assume, for the sake of simplicity, that:

• An individual is willing to forgo $1,000 of current spending.
• He's putting money away for 30 years.
• His income tax bracket (federal and state) during the 30-year period is a constant 40%.
• The before-tax rate of return is a constant 5% per year.

The ordinary savings account starts with $1,000, the amount of current spending the investor is willing to forgo. Given a 40% tax bracket, the earnings compound at an after-tax rate of 3%, so at the end of 30 years, the investor has $2,427 in spendable cash.

The traditional IRA starts with $1,666.67, since, given the tax deduction and a 40% tax rate, that's the amount that entails forgoing $1,000 of current spending. The earnings will compound at a tax-deferred rate of 5%, so at the end of the 30 years there is $7,203 in the traditional IRA. When the investor withdraws the entire amount and gives up 40% in tax, he's left with $4,322 in spendable cash – 78% more than if he hadn't used the IRA.

How does a Roth IRA stack up against a traditional IRA? Redo the calculations for a Roth and you find the same result, to the penny. The Roth starts with $1,000. The earnings grow at a tax-free rate of 5%, so at the end of the 30 years, there is $4,322 in the Roth IRA. And since withdrawals from a Roth can be tax free, it's all spendable cash.

There is a fourth possibility, which I'll call a "Lame IRA." A Lame IRA is a traditional IRA that has been funded with contributions that were non-deductible because the owner's income was too high. Like the Roth, it starts with $1,000, and at the end of the 30 years the balance is $4,322. But of that amount, $3,322 is taxable when it is withdrawn. After paying tax, the owner is left with just $2,992 in spendable cash. This is the weakest outcome for an IRA, but it still beats an ordinary savings account.

The Free Hand You Don't Have

A 78% improvement in wealth accomplished with a traditional IRA is a big payoff for filling out a few papers. So if you had a free hand – meaning if there were no contribution limits – how much of your income and assets should you put into a traditional IRA?

Part of the answer is easy: any interest-earning dollar assets (cash, money market funds, T-bills, taxable bonds, etc.) that are part of your overall portfolio should go into the IRA. In your hands, the interest they earn is heavily taxed. Inside the IRA, the interest is tax-deferred. The ideal IRA would be at least big enough to hold all your interest-earning dollar assets.

The same goes for any part of your portfolio that you plan on devoting to short-term trading – trades that you expect to last for less than one year and hence would generate short-term capital gains. Unless you have an unhappy inventory of capital losses, your short-term capital gains will be taxed at the same rate as ordinary income, and they'll be taxed currently – unless they happen inside your IRA. So your ideal IRA would be big enough to hold all your short-term trades as well.

Longer-term positions are a different matter. Unless your traditional IRA has a long life ahead of it (at least 20 years), you shouldn't expand the IRA to make room for stocks you are holding for more than one year. Putting those stocks into the IRA risks a reverse alchemy – converting lightly taxed long-term gains into ordinary income.

What about gold? The top federal tax rate on gold profits is 28%, which, depending on your state, gets the bill to, perhaps, 34%. In any case, the rate is less than the ordinary income rate you pay when profits come out of a traditional IRA. So if you are planning to liquidate a traditional IRA within the next few years, it's not the place to hold gold. But if your IRA is going to stay in business for another decade or longer, you likely will be selling much of the gold and reinvesting in something else, including interest-earning assets and perhaps short-term trades. In that case, yes, the ideal size for a traditional IRA would be big enough to hold most of the gold that is part of your overall portfolio.

So, in general, moving your directly owned assets into a traditional IRA would be to your advantage. But there are limits. Moving assets whose return is taxed lightly could be a mistake.

With a Roth IRA, however, the picture is much simpler. Ideally, if it were possible, all your investments should be wrapped up in a Roth, for zero tax when profits are earned and zero tax when profits are paid out to you. Of course, that ideal isn't available, but it demonstrates that with a Roth IRA, bigger is unambiguously better. And that gets us closer to answering the Roth conversion question.

Deconstructing a Traditional IRA

Again assume, for the sake of simplicity, that you face a constant tax rate of 40% far into the future. Regardless of how wonderfully profitable the investments in your traditional IRA turn out to be (or how disappointing), and no matter how long the money stays in the IRA, 40 cents of every dollar that comes out will be lost to taxes. You'll only get the 60 cents to spend. In other words, your traditional IRA is in fact a 60/40 partnership between you and the government.

Now take a close look at your 60% share, which is all you really own. Its returns are free of current tax. And when the partnership liquidates (when money comes out of the IRA), you'll collect your 60% share tax free. Sound familiar? Your 60% share of a traditional IRA is indistinguishable from a Roth IRA. It is a virtual Roth. And the other 40% isn't yours at all.

Viewing a traditional IRA in that light, if the government were willing to sell its share and you could use your directly owned (non-IRA) assets to buy it, would it be smart for you to do the deal? The effect of a buyout would be to move your directly owned assets from their high-tax environment into the shelter of a Roth IRA. And we've already established that it is always better to have a dollar in a Roth than to have a dollar in your pocket. So if the government invites you to buy them out, you should almost certainly accept the offer.

In fact, the government is making you such an offer right now. It's called a Roth conversion. Accept the offer. It's a migration of assets from a high-tax environment to a zero-tax environment. Unless you believe that income tax rates are going to decline drastically, put your wealth on the boat.

Four More Factors

Moving more of your financial life into a tax-free Roth zone is by itself a compelling reason to make a Roth conversion. But there are several more advantages:

Inflation Protection

The years of rapid price inflation that many of us are expecting will increase the value of an IRA's tax protection. Inflation generates profits that are accounting fictions but nonetheless are taxable. A stock whose price doubles during a period when what you buy at the grocery store has gotten twice as expensive hasn't delivered a real profit. But when you sell the stock, your "gain" will be taxed as a capital gain... unless the stock is in your IRA.

The tax picture for interest-earning assets during rapid price inflation is even uglier. Yields on money market instruments tend to rise along with inflation rates, on average leaving the investor with a real, after-inflation return of about 1%. When inflation is running at 14%, for example, you can expect money market returns to be in the 15% neighborhood. But the entire 15%, not just the 1% true return, will be taxed – unless the investment is in a shelter such as an IRA. Avoiding a big tax bill on fictitious income adds to the importance of sending as much of your wealth to Rothland as possible.

No Minimum Distribution Requirement

With a traditional IRA, you must take a minimum distribution every year starting at age 70.5. Your IRA is forced into a slow liquidation, which pushes wealth back into the environment of full taxation. Dollar by dollar, tax deferral comes to an end.

With a Roth IRA, on the other hand, there are no minimum distribution requirements. You can let the money ride as long as you like. In nearly all cases, the best approach is to not touch the Roth until you've run out of directly owned assets. For many investors that means letting the Roth grow tax free for years past age 70.5.

Heal the Lame

If any of your contributions to a traditional IRA weren't tax deductible when you made them, your IRA is, to that extent, lame. The tax cost of moving those contribution dollars to a Roth is exactly zero, and the future earnings of those dollars can come out of the Roth tax free.

Additional Tax Savings

The range of investments that the tax rules permit an IRA to hold is broad – far broader than what you can get with any stockbroker, mutual fund family or insurance company. An IRA is authorized to own real estate of any kind, for example. It can own copyrights, patents and other intellectual property and collect royalties. It can own an equipment-leasing business. It can even have a foreign bank account.

Anyone can gain access to such investments for his IRA by moving it to a custodian that will allow the IRA to own a limited liability company. The individual manages the LLC that his IRA owns, and the LLC buys and owns the investments. It's a way to free yourself up to invest IRA money in almost any way you choose.

The structure can provide an additional benefit. It can cut the tax bill on a Roth conversion by one-third or more. That is accomplished by adopting a valuation strategy that has become commonplace in estate planning.

The amount of taxable income that you recognize on a Roth conversion is equal to the "fair market value" of the property that moves from the traditional IRA to the Roth. For all tax purposes, fair market value means the price that would occur in a transaction between a willing buyer and a willing seller. If the property is a non-controlling interest in an LLC, its fair market value will depend on what's in the LLC and also on the terms of the operating agreement that governs the LLC. With the right terms, that fair market value can be pushed far below the interest's pro rata share of the LLC's assets.

An example may make this less mysterious.

Suppose you have a traditional IRA that owns an LLC that in turn owns $100,000 worth of marketable stocks. Under the terms of the LLC's operating agreement:

• The Manager (you) has the discretion to make distributions at whatever time the Manager chooses.
• No owner of an interest in the LLC may sell it without the consent of the Manager.
• The Manager can be replaced, but only with the unanimous consent of the owners.
• The LLC can be liquidated, but only with the unanimous consent of the owners.
• The operating agreement can be amended, but only with the unanimous consent of the owners.

How much would anyone be willing to pay for a 50% interest in your IRA's LLC? Certainly not $50,000. All he would be getting is the right to wait for you to decide to make a distribution, and he would have no power to get rid of you or to change the rules. So the fair market value of the 50% interest would be less than $50,000. How much less? A professional appraiser would tell you the fair market value of the interest is no more than $35,000 (possibly even less than that).

That valuation discount translates into tax savings. Move a 50% interest in the LLC to a Roth, and you recognize taxable income of only $35,000. The following year, repeat the exercise. That will put the entire LLC, with its $100,000 of assets, under the Roth umbrella, and you will be paying tax on just $70,000 of income.

Jumping

The advantages of converting a traditional IRA to a Roth stack up. Move more of your wealth into a tax-free environment. Achieve greater inflation preparedness. Escape the rules on required minimum distributions. Turn non-deductible contributions into a generator of earnings you can withdraw tax free. Cut the tax cost of getting spendable cash from the IRA by using a valuation strategy when you convert.

The advantages stack up so high that if your traditional IRA could read this article, it would be jumping around the room and waving its arms high and shouting "Convert me! Convert me!" I hope you can imagine hearing that advice and taking it. Every time you or anyone else acts on a legitimate opportunity to save on taxes, he deprives the government of the means for more mischief. You'd be doing us all a big favor. I do my part. Now it's time for you to do yours.

In addition to his role as economist and editor with Casey Research, Terry Coxon is a principal in Passport IRA and the author of Unleash your IRA.

The information included in this article is not to be construed as legal or tax advice; should you consider a Roth conversion, make sure to discuss your plans with your own CPA and tax advisor.

[Another thorny investment area is the world of exchange-traded funds (ETFs); they are not always what they appear to be. This free report on the top ten misleading ETFs will help you avoid the brambles.]

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