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Author: TMFPixy Big gold star, 5000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 76237  
Subject: Roth IRA Contriubtions & Conversions Date: 2/1/1998 5:05 PM
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Greetings, All.

The following is excerpted from a booklet I am writing for my day job on various provisions of the Taxpayer Relief Act of 1997.  It deals with the Roth IRA from the standpoint of contributions and rollovers of traditional IRAs.  I provide it for your information and reading pleasure.  Comments are welcome.

QUOTE:

General.  The Roth IRA introduced by TRA 97 provides a new, powerful means to save for retirement and accumulate wealth.  It's unlike any savings tool with which we're familiar.  We can't get a tax deduction for making a contribution to it, but after the Roth IRA is established  all contributions and earnings may be withdrawn free of taxes provided we meet a few relatively simple conditions.  Unlike traditional IRAs, no withdrawals are mandatory,
and should we die our heirs will receive the entire balance tax-free.  Additionally, provided our AGI is no more than $100,000 and we pay all taxes previously deferred, we may convert existing traditional IRAs to a Roth IRA.  On conversion, these IRAs will also enjoy the tax-free benefits provided by the Roth.

Despite the potential for tax-free withdrawals, the Roth IRA may not be the best retirement accumulation tool for everyone.  Each of us must look at our own situation to determine what course of action is best for us.  Our age, the length of time before we need the money, our tax rates today versus those of tomorrow, and our net worth all play a part in deciding how to use this new option.  

Contribution Comparisons.  A traditional IRA is "back-loaded."  This means that, subject to limits, the contribution is untaxed when it enters the IRA, but it and all earnings thereon will be taxed on withdrawal.  A Roth IRA is "front-loaded," which means contributions create no deduction in today's taxes, but on withdrawal they and all earnings are received free of tax.  Thus, our problem becomes one of comparing the "front-loaded" Roth IRA to the
"back-loaded" traditional IRA.  Should we pay taxes at today's rates to receive tax-free proceeds tomorrow (Roth IRA)? Or should we take today's tax deduction and postpone taxes until tomorrow when we may be in a lower tax bracket (traditional IRA)?

To examine this issue, we need to look at two scenarios.

Scenario 1.  John makes a tax-deductible 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.  He wonders how he would fare in the Roth IRA as compared to the
traditional IRA over time, assuming the latter will be taxed at the same marginal rate in the future.  He also wonders what the comparison would be if his marginal tax rate decreases when he begins IRA withdrawals. Both investments will earn a 9% annual rate of return.

Table 1 reveals that if John's tax rate remains the same, the Roth IRA and the traditional IRA will provide the same net income after consideration of income taxes.  However, if John's marginal tax rate declines at withdrawal, as it does for many retirees, then he is better off in the traditional IRA. 

                Annual Contributions to Roth IRA 
           As Compared to Traditional IRA (After Taxes)	
			
Year	Roth	Before Tax	After 28%	After 15%
5	$9,394	$13,047	$9,394	$11,090
10	$23,847	$33,121	$23,847	$28,152
15	$46,085	$64,007	$46,085	$54,406
20	$80,301	$111,529	$80,301	$94,800
25	$132,947	$184,648	$132,947	$156,951
30	$213,948	$297,150	$213,948	$252,578
35	$338,580	$470,249	$338,580	$399,712


                                 Table 1

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 after-tax 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.)  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 long-term capital gain rate of 20% on withdrawal for a taxpayer in the 28% marginal bracket and at 10% for one in the 15% bracket.  Table 2 shows the results of this approach.

        $2,000 Annual Contribution to Roth IRA As Compared to Traditional IRA & Taxable Investment Account (After Taxes)							
							
		28% Bracket			15% Bracket		
		Ded IRA	Inv Acct	IRA/Inv	Ded IRA	Inv Acct	Ded IRA
Year	Roth	After Tax	After Tax	Total	After Tax	After Tax	Total
5	$13,047	$9,394	$2,859	$12,253	$11,090	$3,216	$14,306
10	$33,121	$23,847	$7,107	$30,954	$28,152	$7,995	$36,148
15	$64,007	$46,085	$13,420	$59,505	$54,406	$15,097	$69,503
20	$111,529	$80,301	$22,800	$103,101	$94,800	$25,651	$120,450
25	$184,648	$132,947	$36,740	$169,687	$156,951	$41,333	$198,284
30	$297,150	$213,948	$57,455	$271,403	$252,578	$64,637	$317,215
35	$470,249	$338,580	$88,237	$426,816	$399,712	$99,267	$498,979

                                                 Table 2

Notice that if John remains in the 28% marginal tax bracket when he takes his savings, then in every time period the Roth IRA will provide a greater income than the combination of the traditional IRA and the taxable investment account after both have been taxed.  However, if John's tax rate declines in retirement, the Roth IRA is definitely inferior to the traditional IRA when the latter is used in concert with the taxable investment account.

Note: Based on 1997 marginal tax brackets, taxpayers in the top three tax rates (i.e., 31%, 36%, and 39.6%) are ineligible for a tax deductible traditional IRA.  Those in the 39.6% bracket are also ineligible for a contributory Roth IRA.  For eligible 31% and 36% taxpayers, the contributory Roth IRA is a better alternative than is the nondeductible regular IRA.  Neither results in a current tax deduction, but all Roth proceeds are untaxed on
withdrawal.  In the nondeductible traditional IRA, earnings are subject to taxation when withdrawn.  For the 39.6% taxpayer, the only IRA alternative is the nondeductible traditional IRA.

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 the tax rate stays the same in retirement, neither choice has an income tax advantage over the other during the owner's
lifetime.  (Note: Because the Roth IRA passes tax free to heirs at death, it has the advantage from that standpoint.)  To beat the traditional deductible IRA, an after-tax contribution to a Roth IRA must be exactly equal in dollars to that made to the traditional IRA.

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.

Scenario 3.  Jane, who is younger than age 59 ½, has $50,000 in a previously untaxed IRA.  She wants to rollover that IRA to a Roth IRA.  Her return in either the Roth IRA or the traditional IRA will be 9% per year.  Jane cannot afford to pay the income taxes due on the conversion, so she will keep enough money from the rollover to pay all taxes due in 1998 and later years.  She wants to know if conversion will result in a better income for
her in retirement.

In this situation, the first problem is to determine how much she must withdraw from the traditional IRA to pay her taxes and the 10% penalty that will be due on the entire withdrawal because she is younger than age 59 ½.  This can be done by using the formula W = T + 0.1W in which W is the total amount of withdrawal and T is the total amount of taxes due on the value of the converted IRA.  The formula can be reduced to 0.9W = T.

If Jane is in the 15% marginal bracket and if her IRA is worth $50,000, then on conversion she will owe $$7,500 in ordinary income taxes.  That means:

0.9W = T 
0.9W = $7,500
W = $7,500 / 0.9 = $8,333

Jane can then withdraw $8,333 from her traditional IRA, convert the remainder ($41,677) to the Roth IRA, and have enough to pay her ordinary taxes of $1,875 over each of the next four years (a total of $7,500) plus her $833 early withdrawal penalty in 1998.  The $833 is 10% of the total amount withdrawn from the converted IRA.  For the purposes of this illustration, we will ignore any earnings she may receive on the amount she has retained to pay
future taxes on the rollover.

The procedure described above was used to calculate the results of converting her IRA assuming she was in the 15%, 28%, or 31% tax bracket in 1998.  After-tax comparisons of the Roth IRA to the traditional IRA for each marginal tax rate are at Table 3.  In every case, the Roth IRA fails to match the after-tax results of the traditional IRA.  This failure is due to the lost investment opportunity on the money she withdrew from the converted IRA to pay
her taxes on the conversion.

                               Roth IRA Conversions	                 Taxes and Penalty Paid from Converted IRA						
	15% Bracket		28% Bracket		31% Bracket	
		Ded IRA		Ded IRA		Ded IRA
Year	Roth	after Tax	Roth	after Tax	Roth	after Tax
5	$64,110	$65,392	$52,996	$55,390	$50,433	$53,083
10	$98,641	$100,613	$81,541	$85,225	$77,597	$81,674
15	$151,771	$154,806	$125,462	$131,129	$119,393	$125,666
20	$233,519	$238,187	$193,038	$201,759	$183,701	$193,352
25	$359,298	$366,481	$297,013	$310,431	$282,647	$297,496
30	$552,824	$563,876	$456,992	$477,636	$434,888	$457,735
35	$850,589	$867,594	$703,139	$734,903	$669,129	$704,282

                                   Table 3

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 account has an after-tax 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.)  For fairness, the lost principal and growth on her withdrawals must be added to the traditional IRA proceeds because had the money not been used for the Roth IRA, the investment would have been grown through the years and been available for withdrawal in retirement.  Assume growth in this investment account will be taxed at a long-term capital gain rate of 20% on withdrawal for a taxpayer in the 28% marginal bracket and at 10%
for one in the 15% bracket.  Table 4 shows the after-tax results of this approach for Jane if she remains in her present tax bracket of 28% or falls to a 15% marginal tax rate at the time of the withdrawal.

                             Roth IRA Conversions
Taxes and Penalty Paid from Taxable Investment Account							
		28% Bracket			15% Bracket		
		Ded IRA	Inv Acct	IRA/Inv	Ded IRA	Inv Acct	Ded IRA
Year	Roth	After Tax	After Tax	Total	After Tax	After Tax	Total
5	$76,931	$55,390	$14,837	$70,227	$65,392	$16,691	$82,083
10	$118,368	$85,225	$16,060	$101,285	$100,613	$18,067	$118,680
15	$182,124	$131,129	$17,384	$148,513	$154,806	$19,557	$174,362
20	$280,221	$201,759	$18,817	$220,576	$238,187	$21,169	$259,356
25	$431,154	$310,431	$20,368	$330,799	$366,481	$22,914	$389,395
30	$663,384	$477,636	$22,047	$499,684	$563,876	$24,803	$588,679
35	$1,020,698	$734,903	$23,865	$758,768	$867,594	$26,848	$894,441

                                             Table 4

Table 4 reveals that if Jane remains in the 28% tax bracket at withdrawal, the use of other assets to pay the tax due on the conversion of her old IRA makes the Roth IRA a clear winner.  The total of her traditional IRA and her investment account after taxes is less than the total for the Roth IRA.  If her marginal tax rate drops to 15% when she begins withdrawal, the traditional IRA is best when those withdrawals start within 10 years.  At 10 years,
the traditional IRA has a slight edge over the Roth IRA.  For holding periods longer than 10 years, the Roth IRA is a better alternative.

Conclusions Regarding Roth IRA Conversions.  When funds are taken from the converted IRA to pay income tax due on the conversion, the Roth IRA will be an inferior option to the traditional IRA.  This holds especially true if the withdrawal to pay those taxes also results in an early withdrawal penalty.  When taxes due on the conversion are taken from other taxable assets, the Roth IRA is a more attractive option.  For those who remain in the
same marginal tax rate at the time of withdrawal, the Roth IRA is a clear winner.  For those who drop to a lower tax bracket at withdrawal, the Roth IRA must be held for more than 10 years to beat the traditional IRA.

UNQUOTE

Regards.........Pixy









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