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Subject: Re: Roth IRA Contriubtions & Conversions  Date: 2/2/1998 4:33 AM  
Author: Kilmarnoch  Number: 1570 of 76882  
is it done yet? this is kinda long... (547 lines). if you think this takes a while to read, think about how long it took to write. =) I should have prolly broken this up into 3 parts... i'll do that next time If I get a bunch of flak about the size of this. hopefully there are enough errors to spark at least one reply. and hopefully someone else understand something I wrote here. ========================================== to summarize (and fan the fires :) this is what I think is true: general statements of fact:  always max out your IRA options, every year!  if you are not eligible for a tax deductible IRA, then a roth is *the* best option.  if you are eligible for a tax deductible IRA then a traditional IRA *only* makes sense if you will retire in less than 20 years.  if you are not eligible for a Roth (lucky you), put your money into a traditional IRA... then evaluate a rollover to Roth when you stop making so much money. MAJOR DISCLAIMER: ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ I expect people to not believe these numbers... there is prolly also going to be some misunderstanding. Who knows all my numbers might be completely bogus? Please ask questions about how I calculated a particular table if it looks fishy, and please point out any place that my rates are bogus. (But explain what about them is bogus, and how you think the numbers are fishy so I can correct them =) ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ END OF MAJOR DISCLAIMER. now for the post... ============================= TMFPixy wrote everything quoted like '>' [tangent 1... >Investments will earn a 9% annual rate of return... why not pick an easier number say like 10%... as long as the number stays the same in all charts it doesn't hurt the comparison. 10% is a *whole bunch* easier to visually verify. (note: even though I am whining about it over here I will continue to use 9% in my reply ;P ) all math was done to an insane number of decimal places. ...end tangent] >Scenario 1. > > John makes a taxdeductible contribution of $2,000 per year to a >traditional IRA. He is considering the new Roth IRA, but must maintain >the same net income he has today using the traditional IRA. John is >in the 28% marginal tax bracket, which means he may only contribute >$1,440 to a Roth IRA to keep his net income the same as it is by using >the traditional IRA. Okay... here is a problem. Remember that bit about the difference between effective tax rates and tax brackets rates? I rambled something about: :The main point of this is that just because you are "in the 28% tax :bracket" does *NOT* mean you pay 28% in taxes. being at the very top of :the 28% tax bracket you only actually pay 22% in taxes... the lower in :the bracket you are the lower the percent of your income you pay to tax, :(tax ranges from 15% upto 22% in the "single's 28% bracket", and 22% :upto 26% in the "single's 31% bracket", etc...). I really really suggest that for chart purposes people use 15.0% and 22.6% as the two tax rates... and maybe something in the middle like 19.99%. the idea that "being in the 28% tax bracket means that you pay 28% tax" is so plain wrong, the most you will *ever* pay in the 28% bracket is effectively 22.6% and that is only if you are earning at the _very_ top of the bracket!  The "most" refund he would get for a deductible IRA contribution is somewhere between 15% and 22% of the amount invested... that is if you still *qualify* for a full deduction: your effective $2000 deduction you make ... tax rate is ... is worth ================================================== $20000 ... 15.00000000% ... $300.00 $25000 ... 15.18200000% ... $303.64 $30000 ... 17.31833333% ... $346.37 $35000 ... 18.84428571% ... $376.89 $40000 ... 19.98875000% ... $399.78 $45000 ... 20.87888888% ... $417.58 $50000 ... 21.59100000% ... $431.82 $55000 ... 22.17363636% ... $443.47 $59750 ... 22.63682008% ... $452.74 ... the more you make the bigger the tax rebate ... example 1: John makes $40k per year, so his effective tax rate is 19.99%.... if he put 2000 into a traditional IRA he would get $399.78 back in a tax refund.  so he puts $2000.00 yearly into a traditional IRA *or*  so he puts $1600.22 yearly into a Roth IRA example 2: John makes $20k per year, so his effective tax rate is 15.00%.... if he put 2000 into a traditional IRA he would get $300.00 back in a tax refund.  so he puts $2000.00 yearly into a traditional IRA *or*  so he puts $1700.00 yearly into a Roth IRA so the following is my revision of Table 1, assuming that John *can* make a fully deductible contribution and choices to make a 2000 dollars worth of "pre tax" dollars into both types. This uses effective tax rates to calculate the amount put into a Roth IRA (see examples above). (in the end: bigger numbers are better *=) Kilmarnoch's Table 1: Annual Contributions to Roth IRA As Compared to Traditional IRA (After Taxes) effectively put  2000 pretax $ into Roth IRA  Trad IRA you make  before after effective tax 50,000 40,000 30,000 20,000  tax 15.0% 18.8% 22.6% ========================================================================= 5 10229 10438 10787 11089  13046  11089 10591 10093 10 25969 26500 27384 28152  33120  28152 26887 25623 15 50187 51212 52921 54405  64006  54405 51961 49517 20 87448 89235 92214 94799  111529  94799 90541 86282 25 144780 147739 152670 156950  184647  156950 149900 142849 30 232992 237753 245688 252577  297150  252577 241231 229885 35 368717 376252 388810 399712  470249  399712 381755 363799 ^^^^^^ this column does not count Notice that the 20K per year and the 15.0% traditional IRA case match identically... because the effective rates are the same going in and coming out. So what's the result of using the effective rate? It makes the Roth IRA look *MUCH* less of a bad choice if your effective rate is 15% in retirement (compared to the nonlogic of the 28% > 15% charts). [tangent 2... ...think of the chart above as a "snapshot in time"... Effective rates are show removing from the traditional IRA... this is a little bogus, because it assumes either:  the money is taken out as one lump sum (which isn't possible at some of the effective rates show) *or*  the money stops earning any interest (right ;) and is taken out over a series of years at the effective rate show To *really* do the this right I need an estimated life span over which to spread the withdrawals (from both the Roth and traditional IRA) accounts... this would allow me to calculate the *real* effective rates on the withdrawals from the traditional IRA each year as they are withdrawn. tangent 3... how many people who make 50K and still qualify for a full deduction??? maybe 2% of the population? ;) ... end tangents] MAJOR DISCLAIMER: ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ [this was the original location of the disclaimer it applies a *whole bunch* to the following, post] ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ END OF MAJOR DISCLAIMER. Scenario 2.  > Assume John's circumstances are the same as before except that he will >deposit $2,000 annually into the Roth IRA. To do so, he will forego >contributions he was making to a regular investment account that has >an aftertax return of 8.244% per year. (Note: The total return on >this account is 9%, of which 30% comes from taxable dividends and 70% >comes from long term capital appreciation.) I think the 8.244% return per year on the after tax account is bogus... here's my math: return = (rate * 70%) ... taxed at capital gains rate + (rate * 30%) ... taxed at effect tax rate return = (rate * 70% * [percent that you keep after capital gains tax]) + (rate * 30% * [percent that you keep after max effective tax]) for someone in the 28% bracket return would be: 7.1288058578 = (9.0 * .7 * .8) + (9 * .3 * .7736317992) for someone in the 15% bracket return would be: 7.965 = (9.0 * .7 * .9) + (9 * .3 * .85) did I miss something here? does this make sense? >For fairness, the lost >principal and growth on this additional $560 deposit must be added to >traditional IRA proceeds because the foregone investment would have >been available for withdrawal in later years. Assume growth in this >investment account will be taxed at a longterm capital gain rate of >20% on withdrawal for a taxpayer in the 28% marginal bracket and at 10% >for one in the 15% bracket. So in my version of table 2...  He is going to max out his Roth contributions, (2000 a year). Which means to be fair to the traditional IRA...  he needs to put 2000 into the traditional *and*  then put his entire tax refund into a taxable account earning the "post tax" return rate. ;) Kilmarnoch's Table 2a: So what would happen if you are paying 22.6% effective taxes and you max out as above, *then* move to the 15% effective rate at retirement?... *this* is the interesting part ;P notes: while working the individual account earns 7.1288058578% after tax all other accounts earn 9%. while working the individual account receives 452.73 a year at retirement the tax rate shifts instantly to 15% effective.   Deduc Indiv  Deduc Indiv   IRA Acct  IRA Acct   Before Before  After After Year  Roth  Tax Tax Total  Tax Tax Total ============================================================= 5  13047  13047 2796 15843  11090 1613 13466 10  33121  33121 6742 39863  28152 3981 33883 15  64007  64007 12309 76316  54406 7454 64868 20  111529  111529 20165 131694  94800 12549 111939 25  184648  184648 31249 215897  156951 20023 183512 30  297150  297150 46890 344040  252578 30988 292434 35  470249  470249 68958 539207  399712 47072 458325 So this table assumes the *worst possible* tax rate (in the 28% bracket) over the working career, then the *best possible* tax rate at retirement. Notice how the Roth wins after 20 years? also notice how the the traditional wins only by $800 dollars at it's peak? But after 35 years Roth is ahead by $12000??? ___With___the___current___tax___scheme___ long term Roth is a no brainer. The higher the effective tax rate the larger the differences are at the ends of the time spectrum. It takes the *same* amount of time for the Roth to "pull ahead". (the top end of the 31% tax bracket has an effective tax rate of 26.99117529%)... doing everything the same as above moves the return on the taxable account to 5.7687617328%, and moves the tax rebate to 539.82 per year. We are still going to assume the retiree moves straight into the 15% effective tax rate. Kilmarnoch's Table 2c: post tax return rate: 5.7687617328 = (9.0 * .7 * .8) + (9 * .3 * .2699117529) tax rebate: 539.8235058000 = 2000 * .2699117529   Deduc Indiv  Deduc Indiv   IRA Acct  IRA Acct   Before Before  After After Year  Roth  Tax Tax Total  Tax Tax Total ============================================================= 5  13047  13047 3203 16250  11090 2723 13812 10  33121  33121 7444 40565  28152 6327 34480 15  64007  64007 13058 77065  54406 11099 65505 20  111529  111529 20488 132017  94800 17415 112214 25  184648  184648 30324 214972  156951 25775 182726 30  297150  297150 43343 340493  252578 36842 289419 35  470249  470249 60577 530826  399712 51491 451202 note:  short term the difference is more in favor of traditional IRAs.  long term the difference is more in favor of Roth IRAs Also, people at the top of the 31% tax bracket aren't even eligible for a Roth IRA... so continuing this series of graphs any higher is moot. [tangent 4... I don't know the exact number of years it takes for Roth to pull ahead but I'm interested in what it is... I'm guessing it's about 22.5 years can any math types out there explain why that is the case? ...end tangent] >Conclusions Regarding IRA Contributions. > > In choosing between a tax deductible traditional IRA and a Roth IRA, >our marginal tax rate today versus that of tomorrow is important. >If the tax rate declines when the money is withdrawn, those who end >up in a 15% tax bracket will not benefit from Roth IRA contributions. *IF* my tables above are not completely wrong, then you need to rewrite that conclusion. ;P ahhhh... now what _about_ those conversions? [you might want to take a break at this point... I *need* to switch music, perhaps it's time for a drink? ;] >Traditional IRA Conversions to a Roth IRA. > > TRA 97 allows taxpayers to convert traditional IRAs to Roth IRAs provided >their AGI is under $100,000 in the year of conversion. (Note: Based >on 1997 tax brackets, this means only those with a 15% or 28% marginal >rate are eligible for a Roth IRA conversion.) No penalty applies, but >ordinary income taxes must be paid on previously untaxed IRA proceeds. >If the conversion occurs in 1998, the income from the IRA must be spread >equally over four years for taxation. Conversions made in 1999 or later >will be fully taxed in the year they occur. If money is withdrawn from >the converted IRA to pay taxes, the 10% early withdrawal penalty will >apply for those younger than age 59 ½. some more general statements of fact:  if must use IRA funds to convert don't even think about it (the tax twits will slap you hard).  if you can convert to a Roth IRA with outside funds do it. Thanks to those "facts" above I'm tossing out Scenario 3... which has someone trying to use IRA funds for the rollover. Most people who "should" rollover must save money outside the IRA to do the rollover with, the rollover is not worth it otherwise. I would prefer to stick to lump sum rollover examples, because provided that you stay in the same tax bracket you will *always* pay more on a lump sum rollover than a 4 year spread out rollover and the spread rollover is only available in this one year. So if a lump sum rollover makes sense then a spread out rollover will always make "more" sense. I will also assume that *all* of the amount is taxable, simply because that is the worst case example for the Roth. Despite both disadvantages the Roth rollover is a no brainer... [tangent 6... I would like for all of the following examples to use 2000 per year contributions to the resulting Roth ... and 2000 + rebate to the nonrolled over traditional IRA (but my head is beginning to hurt ;) so I'm going to keep it simple: no contributions to any account after roll over (i think donations might give the traditional account an slight short term advantage). ...end tangent] >Scenario 4. > > Jane is in the 28% tax bracket and has a $50,000 traditional IRA she >wants to convert to a Roth IRA. She will pay all taxes due on the >conversion from other assets. To do so, she will withdraw the taxes due >each year from a regular investment account. [the after 8.244% tax return rate was bogus in the example above] side note: Jane is currently about 34 years old... (starting at 21, 13 years of max contributions with a 9% return results in $50k), so 25 year forecasts put her at the "penalty free withdrawals" age. 35 years puts her at the point that she *must* start making withdrawals from a traditional IRA. Kilmarnoch's Table 4a: Roth IRA Conversions Taxes and Penalty Paid from Taxable Investment Account taxable account returns 7.1288058578% (worst 28% bracket return) 22.6% effective at conversion  Ded Inv IRA  22.6%  15.0%  IRA Acct &  Total  Total  Before Before Inv  After  After Year Roth  Tax Tax Total  Tax  Tax =========================================================== 0 50000  50000 14630 64630  50000  54935 5 76931  76931 20643 97574  75486  82937 10 118368  118368 29127 147495  114106  125370 15 182124  182124 41099 223223  172692  189739 20 280221  280221 57992 338213  261652  287481 25 431154  431154 81827 512981  396858  436033 30 663384  663384 115460 778844  602538  662017 35 1020698  1020698 162915 1183613  915680  1006071 Roth is a no brainer win after 10 years for level, and 30 years for 22.6 > 15.0 % changes in tax rates. Well now... 50000 as a lump sum is going to really raise the AGI... which means it might "push" this poor person into the higher 31% bracket! So let's do the math as if it does: Kilmarnoch's Table 4b: Roth IRA Conversions Taxes and Penalty Paid from Taxable Investment Account notes: taxable account still returns 7.1288058578% (worst 28% bracket return) but the effective tax rate when the conversion happens is 26.99117529% this is the *highest effective tax rate* in the 31% tax bracket! that means that she needs $18484.87 at the time of the rollover. the math: needed to rollover = [desired in roth] / [portion you keep after tax] 68484.8717926992 = 50000 / (1.0  .2699117529) to check the math: [amount in roth] = [amount taxed] * [amount you keep after tax] 50000 = 68484.8717926992 * .7300882471 27.0% effective at conversion  Ded Inv IRA  22.6%  15.0%  IRA Acct &  Total  Total  Before Before Inv  After  After Year Roth  Tax Tax Total  Tax  Tax =========================================================== 0 50000  50000 18484 68484  52981  58211 5 76931  76931 26081 103012  79693  87560 10 118368  118368 36800 155168  120042  131892 15 182124  182124 51926 234050  181068  198942 20 280221  280221 73269 353490  273471  300466 25 431154  431154 103383 534537  413534  454356 30 663384  663384 145876 809260  626069  687871 35 1020698  1020698 205833 1226531  948883  1042551 wow?!? Notice the traditional beats Roth hands down over time for the 27% conversion > 15% retirement? how is that? [tangent 5... the test mentioned here was discovered as I was writing my reply I've developed a headache and don't want to test all these numbers with a different rate of return, but I suspect that the higher the return rate the more a Roth helps you (because it saves you more in tax each year) ...end tangent] the 35 year test: [convert test] = [conversion effective rate]  [retirement effective rate]  [investment growth rate] if convert test is less than zero you should do the conversation. if convert test is grater than zero you should not convert. in the first 22.6 > 15.0 example: convert test = 1.36317992 = 22.63682008  15.0  9.0 difference between roth and traditional = 1.0145387353 = 1020698 / 1006071 a roth IRA earns 101.45387353% of what a traditional would (winning). in the second 27.0 > 15.0 example: 2.99117529 = 26.99117529  15.0  9.0 difference between roth and traditional = .9790389151 = 1020698 / 1042551 a roth IRA earns 97.90389151% of what a traditional would (lossing). You should notice that the roth is favored more over time... because my little "covert test" formula is off by some factor in favor of the roth. if a math type would like to explain how/why that is I'm all ears. =) I'm sure that my test as described above is not 100% correct. But I am also *SURE* there is some formula that takes into account the short term and long term periods and answers one of the following questions (the formula *must* exisit): "How many years will it take, with an effective conversion rate of [A], with a tax able account growth rate of [B] and a nontaxable growth of [C], for a roth IRA to beat a traditional IRA, if at retirement my effective tax rate is [D]?" *or* "After [A] years, how much does a roth beat a traditional, when the effective conversion rate of was [B], a tax able account growth rate is [C], non taxable growth is [D], and at retirement my effective tax rate is [E]?" anyone like word problems? *=) Later,  Kilmarnoch ps. What I would really like to talk about is what people think congress is going to do about the SS and debt problems in the future... how they handle that is going to have a major effect on what the best place to store our money is. If the simply crank up the tax rates but mostly keep the current system (highest bracket in the mid50's ... 45%, 35%, 30%, lowest bracket at 20%)... Roth will win hands down. (provided it retains it tax free nature =) If they add a national sales tax of some sort, and do away with income tax (right next pipe dream), traditional wins. If they don't do away with income tax and add a sales tax, roth wins. I know it's alot of speculation, but I also know *SOMETHING* is going to happen before I reach 50... and I'm concerned. =) 

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