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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.
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Traditional
IRA
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Government's
share = 40%
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Your
Virtual Roth IRA = 60%
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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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