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burlew is stumped:

Please help I am stumped. I am 27 single and have $17,100 sitting in the TSP (the governmnet's 401K plan) despite having left over a year ago. One of our advisors that works with my present employers is trying to get me to roll this over to my existing Roth IRA.

I talked with financial guru Ric Edleman last night and he said it would be better to roll over to a deductable regular IRA. He said the advisor who gave me this advice never looked at a spread sheet and that the object of investing is to create wealth not lower taxes.

I am confused, my "advisor" says sure I will have to pay taxes on the $17,100 next year but then never again with a Roth. What should I do? On the surface the Roth seems like a better way to go....

While I'm not a guru, I think the analysis is pretty simple. Let's try:

Taxes to be paid now if you do the Roth conversion: If we guess your marginal tax rate is about 30%... so you'll have to pay $5130 tax on the rollover. If you don't have an extra $5130 available now (it must be "after tax" money... you can't take it from the IRA... that costs even more in penalties!), then the Roth plan is out.

But let's say you've got an extra $5k... maybe it's the hiring bonus for the new job, or something... or maybe you've been a better saver than most of us. So we can compare:

Assumptions: We'll assume that you use the same investment strategy in the Roth or non-Roth plans. So we can assume you'll have the same percentage gain, which we'll call X. You've got a lot of years, so we hope that X is large... but it's the same in either plan.

Roth plan result:

You put your $17,100 into the Roth, paying the $5130 in tax. In umpteen years, it becomes (17100 * X), which you can then take out, tax free.

Future risk: This assumes that there are no changes in how Roth IRAs work, and they remain untaxed.

Result: (17100 * X)

Non-Roth plan result:

You put your $17,100 into a "regular" IRA, and keep the extra $5130. You invest the $5130, too, since you don't need to pay any tax. In umpteen years, the regular IRA becomes (17100 * X), and you then start taking withdrawals....

Future risk: Now, we try to guess your tax rate in the future. If we assume that it's going to be the same exact marginal rate (which was set at 30%), then the future tax is going to be 30% of (17100 * X) which is (5130 * X), right?

But wait... this future tax is just about exactly what would be earned by investing the $5130 that you saved by not converting to a Roth. Assuming that you get the same earning rate, you should have (5130 * X) earned by the time you need it.

Now, you might think that the 30% rate isn't enough, because X is large, so (17100 * X) is a lot. But remember that you take your retirement money out slowly, and pay the tax as you need it. So it's not unreasonable to assume that you'll take out from the IRA just about what you earn now... and so pay the same marginal rate.

Result: (17100 * X)

So, they match?

Well, yes, but that match is only as good as your assumptions about the tax rate you pay now versus the tax rate you will pay in at retirement. The solution is to guess what happens in the future, and bet accordingly. This is very hard.

My personal solution for this is to spread my investments between the regular IRA (mostly funded by 401(k) rollover) and others. That way, I'll have to pay some tax at retirement time, but I'll also have some money which has been already taxes, either in my Roth IRA or my after-tax investments.

How gurus think:

I believe that the non-Roth gurus are working on the assumption that you'll pay lower taxes at retirement. Either they imagine some mystic future-world, or they think you're going to retire cheaply. I think this is a bad assumption; I personally plan to retire rich... or die trying.

I believe that the Roth gurus are assuming that marginal tax rates are going to get worse, so pay now while they're pretty low. I see no data to support this assumption. If anything, I don't trust the government to leave all that Roth money untaxed.

Maybe the Roth gurus have another idea... maybe they think that you can't be trusted to save the $5130 now... so by making the conversion, you're forced to "save" it by paying it as tax now, rather than spending it. This assumption makes more sense.

Have either of the gurus actually done this math? I don't know; but I don't trust gurus one bit. And they didn't give you this simple explanation that I've given you... they just give you guru pronouncements. Fooey on gurus.

That's my analysis. The decision ought to be made based on whatever balance your crystal ball tells you about the tax rates in the future. If you make medium assumptions, it's a wash.

I'd enjoy reading arguments with this, since I'm basing my planning on it. As always, it's your money, and you should place your own bets.

Fool On!

Dick Smith
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