By Robert Braglia
Ever since Roth IRAs came out (and every time the regulations are tweaked), the conventional wisdom is “Just do it!” As is often the case, the conventional wisdom is “Just wrong.”
There are a few scenarios where it is a good idea but, in most cases, it is a trap!
What else can you call a scheme, cooked up by Congress, to get you to pay taxes years, if not decades, sooner than they would otherwise be due? Don’t forget, if you are married, the deferral, beyond the required minimum distribution (RMD), isn’t just your life but also the life of your surviving spouse.
Here is the sales pitch: Pay taxes on the money now, either by foregoing the deduction on contributions, or actually paying out of pocket for a conversion, but never be taxed on the money again. Sounds like a good idea at first but here is what’s left out – you have significantly fewer dollars working for you (the ones you paid in taxes) for all the years in between.
You can find numerous “break-even” calculators online, into which you must put several assumptions, each of which is a wild guess. “When will you retire?” (It isn’t always voluntary.) “When will you die?” (Pretty much NEVER voluntary), and so on. The granddaddy assumption of them all is, “In what tax bracket will you be 20, 30, or 40 years from now?” We don’t even know what tax bracket we will be in next year.
Then there is a given, which really isn’t a given, that the money coming out will actually NOT be taxed, as promised. Who said so? Congress? That is the same body which promised Social Security benefits would never be taxed. They needed more revenue than they could find, so they changed the law. Hard to imagine them EVER needing more money than they have. (Sorry, I’m from New York and fluent in sarcasm.)
Your tax bracket will either be higher or lower when you pull the money out. If it is lower, the Roth contributions or the conversion may be an obvious mistake. If it is HIGHER, it means that Congress is turning over every bush for revenue and your Roth IRA could be next. It would likely be just on the appreciation and possibly just for the “rich,” but we have all seen how that definition can cover people who are not really rich at all. To escape that categorization, you must be in a low tax bracket which brings you back to the first mistake.
It is pretty clear that in the near future, tax rates are going up. In the long term, however, history tells us that to raise tax revenue, eventually the tax rates must be lowered. That may seem to defy logic but it’s based on the fact that people change their behavior as the rules change. Economists call it dynamic, as opposed to static, analysis. Politicians, for some reason, tend to ignore that when projecting the results of such changes.
Take the money and run or, in this case, take the deduction.
I have seen an even more egregious mistake. After the law was tweaked once, making conversions no longer restricted by income, there was “conversion mania,” with a bombardment of ads touting how great it was. What really happened was that Congress needed more money and realized how easy it was to get some people to pay taxes far in advance. They just expanded the “opportunity.”
A client of mine fell under the spell and told me he wanted to “Roth” a chunk of his IRA. He had the cash to pay the taxes but that could have been deployed elsewhere. I tried to talk him out of it but failed. His accountant supported the idea. His IRA constituted less than half of his investable assets and he had already committed to giving half his estate to charity when he died. Obviously, the IRA assets would be the first to go to charity, untaxed forever, so all he accomplished was to lower the bottom line and paid taxes, not just in advance, but that would never have been due at all.
The fact that he had the cash was irrelevant. I once heard an accountant, well known on the speaking circuit, say, “So, if you have money sitting around doing nothing, convert some IRA money to a Roth and use that to pay the taxes.” Money sitting around doing nothing? Would it not be better to actually do SOMETHING with the money instead of using it to pay taxes years before they are due?
Of course, there are some situations where a Roth IRA is advised. Some people are in a zero or low tax bracket, perhaps early in their career, so the present deduction is of no benefit. I often advise the children of my clients, just starting out in life, to contribute to a Roth IRA, or use the Roth option if they have a 401(k) that offers it. A client’s son called just a few moments ago and I figured that would be the advice I’d give him. Then he told me he made $200,000 this year. No off-the-shelf advice; every situation is unique.
Sometimes, a unique situation presents itself later in life. A client of mine had huge ordinary income write-offs one year and we calculated how much of a Roth conversion they could do for “free,” so to speak. They could still get hit by a change in the law down the road but, at any rate, would not be any worse off than they were in the first place. Another client of mine made a career change as he was approaching 60, finally abandoning his father’s business to pursue his own lifelong dream. Despite his enormous talent as a photographer, the first few years were pretty much income free, so each year we converted a chunk of his IRA.
Will one of these unique situations make a difference for you? 2020 is certainly a unique year. The best bet, as always, is to check with a financial professional whose compensation is not affected by your decision.
About the author: Robert Braglia
Robert Braglia is the founder and president of American Financial & Tax Strategies, Inc., a private wealth management firm dedicated to a prudent process and helping people make intelligent decisions about their money. The company is an SEC Registered Investment Advisory Firm with full fiduciary responsibility.