To convert to Roth or not?

[Koolau]

It might be relevant to your decision in this way... If you believe taxes in the future must be higher, you might be tempted to give more preference to Roth; but then if government decides to increases taxes not so much via income tax but instead via VAT, it might turn out that Traditional IRA was better after all (since your income tax would still be lower but VAT would be the tax making up the difference). So, recognizing this possibility may pull you back to Traditional IRA.

You are suggesting that it's not a "wash" between Trad. and Roth if VAT is thrown into the mix. T-Al suggested it's a "wash". I still don't know how to do the math. Anyone?

 

[TromboneAl]

Let's try a simple example -- I'm essentially thinking out loud here.

You've got $1,000 to convert (or not convert). Your tax bracket is 10% both now and when withdrawing. The money doubles in 10 years, and you withdraw it and buy a $2,000 TV.

You start with $1,1000. $1,000 in a trad IRA, and $100 in a taxable account.

Convert with 20% VAT imposed:
You convert $1,000, and use 100 from the taxable account to pay the tax. In 10 years you withdraw $2,000, buy the TV and pay $400 in VAT. You end up down $400.

Don't Convert with 20% VAT imposed:
In 10 years, the $100 in your taxable account has grown to $187 (it would have doubled, but you paid 10% tax each year). You withdraw $2,000 and pay $200 in taxes. You buy the TV for $2,000 and pay $400 in VAT. You end up down $413.

Convert with no VAT:
You convert $1,000, and use 100 from the taxable account to pay the tax. In 10 years you withdraw $2,000, buy the TV. You end up with $0.

Don't Convert with no VAT:
In 10 years, the $100 in your taxable account has grown to $187 (it would have doubled, but you paid 10% tax each year). You withdraw $2,000 and pay $200 in taxes. You buy the TV for $2,000. You end up down $13.

Conclusion: Whether there's a VAT or not makes no difference.

But, as is often the case, there may be some errors in my math or logic...

 

[Dave J]

I am curious about how many of you out there are planning to convert some or all of their IRA or 401K to a ROTH this year. Also, if you plan to pay all the tax in 2010 or split it up in 2011-2012. ........Again, What are your thoughts!
Thanks

I'm 57 and I 100% retired last year.

In 2009 I converted some of my IRA money to a Roth.

I currently plan on doing the same this year and the next ones until I'm drawing SS and my tax bracket goes up.

I will pay the tax in the year of conversion because I'm afraid taxes have nowhere to go but up with all this spending.

I will then have a variety of before tax and after tax pools of money to help lower my future tax brackets.
I have after tax money to pay my tax due now.

I used ORP Optimal Retirement Calculator and Retirement Decision Support System to aid me in deciding how much and when to convert.It actually slowed down the dollar amounts I was planning on converting each year.

 

[ziggy29]

As I've mentioned in another thread about doing my mom's taxes this year, if the RMDs in a traditional IRA would result in a much higher taxation of your SS benefits, a Roth conversion might make sense even if you don't expect to be in a lower marginal income tax bracket in retirement. It's certainly opened my eyes to another aspect of tax planning for retirement.

 

[Koolau]

It's certainly opened my eyes to another aspect of tax planning for retirement.

It does seem that our tax system is full of trip wires and land mines. I think it was Scott Burns who a few years ago demonstrated how it was possible to have an effective 100+% tax on a portion of a 2-income family's income. Paying for SS on the 2nd spouse was never compensated because they would have received 1/2 of the first spouse's SS anyway. The 85% taxable on SS came into it and there were some other wrinkles as well. The result was that for some significant portion of the 2nd spouse's income, it cost the couple money for the 2nd spouse to work. This had nothing to do with cost of work. It was strictly a tax thing. Since part of the "effect" wasn't realized until after SS payments began, it probably wouldn't be noticed, even with normal tax planning.

 

[smjsl]

You've got $1,000 to convert (or not convert). Your tax bracket is 10% both now and when withdrawing. The money doubles in 10 years, and you withdraw it and buy a $2,000 TV.

Once you pick a specific scenario of tax brackets now and later, there is no difference with and without VAT. Problem is you have to make a choice while guessing what the scenario will be. Whether to convert to Roth or not depends on whether you think you will end up in higher income tax bracket or not. If you end up in lower bracket, you should convert. If you end up in higher one, most likely you should not. Now, how do you decide?

If taxes were very high and you thought they will go lower, you most likely would not convert to Roth at all. Current situation is more difficult though. On the one hand, it seems like taxes have nowhere to go but up. On the other hand, if your income during retirement will be less than now, you will jump to a lower bracket. So you have to guess which bracket you will end up in compared to where you are now and how that (possibly increased) tax will compare to your current marginal tax... VAT lessens the probability that taxes will go too high, because it's another option for government to take. So, you may figure taxes will not go that much higher, because instead they will create VAT (if you believe in this option)... As a result, depending how much you believe in this theory, you may put more or less money into your Roth bucket.

 

[WilliamG]

This link gives some cons on roth conversion(s). At the least, depending on your other taxable income sources, you wouldn't want to convert all of your IRA since can take just enuf IRA out to fill lower tax bracket(s).

The Case Against Roth 401(k) - The Finance Buff

 

[kaneohe]

Let's try a simple example -- I'm essentially thinking out loud here.

But, as is often the case, there may be some errors in my math or logic...

T-Al, I agree w/ your example. For the longest time, I accepted the VAT argument as making intuitive sense but never looked at it quantitatively.
Now it seems like the VAT doesn't seem to be a big factor in the conversion decision but the idea still seems quite alive.....e.g. at Bogleheads. Have you tried your idea over there?

Perhaps the VAT issue being worried about is if VAT replaces income tax (or if income tax is lowered when VAT comes in). In that case, converting to Roth now subjects you to current tax while withdrawing from TIRA would have no or lower income tax.

 

[ERD50]

Let's try a simple example -- I'm essentially thinking out loud here.

.....

Conclusion: Whether there's a VAT or not makes no difference.

But, as is often the case, there may be some errors in my math or logic...

Perhaps the VAT issue being worried about is if VAT replaces income tax (or if income tax is lowered when VAT comes in). In that case, converting to Roth now subjects you to current tax while withdrawing from TIRA would have no or lower income tax.

I agree - the trouble with T-Al's example is that it is too static. If A VAT is revenue neutral, then we would expect a reduction in income tax rates. So for apples-apples, if we have no VAT, then we should compare that to a 30% tax bracket, right? So, 20% VAT and 10% income tax, versus 0% VAT and 30% Income Tax.

I don't have time now to run the numbers, but I think that is the proper comparison. Some might argue (and they might be right) that the govt will increase both, but that is an analysis of increased taxes, not VAT versus Roth versus T-IRA. But I guess T-ALs point holds for that scenario - *adding* a VAT on top of other taxes doesn't seem to 'hurt' a Roth conversion. But I need more coffee before I commit to that

-ERD50

 

[WilliamG]

REVENUE NEUTRAL!

This country is going to be so revenue hungry who knows what will be implemented. For sure, they will go where the money is.

 

[A Visitor]

Just to make things a bit more complicated, there is the tax-favored treatment of cap gains in effect for 2010. Personally I think I will take as much as I can in cap gains before looking at Roth conversions...

 

[ERD50]

REVENUE NEUTRAL!

It's just for the example. Sometimes you need to enter the 'Twilight Zone" (you are entering another dimension, where tax rates are stable...) to do a straight-up comparison.

-ERD50