November 8, 2010

Example of a Bad Roth IRA Conversion

Lets pretend for a minute shall we?    

Lets say that I'm a single person making $50,000 annual salary.   I put 10% of may pay into a 401k and my stingy employer didn't match it.   Over the past several years I've done pretty well with my investments and I've now got a total of $150,000 in my 401k.   I then switch to a new employer and decide to roll over my 401k money into an IRA.  Now I've got $150,000 in an IRA.   I decide to convert the IRA into a Roth IRA.   Cause thats what people do right?

 I'm normally making $50,000 but $5,000 of that has been tax sheltered in the 401k.  In a normal year I pay $5,094 to the IRS (using 2010 taxes) on my $45,000 income (less the 10% into retirement).     I'm in the 25% tax bracket as a single person.   I'm effectively avoiding a $1,250 tax on my $5,000 by putting it into my 401k.     The 401k savings would have been taxed at 25%.   But I instead didn't pay that and sheltered the savings from taxes.

OK now lets convert that $150,000 into a Roth IRA.   Everyones' doing it, so I guess I should too.  When you roll money into a Roth IRA conversion you have to pay the taxes on it.  My normal income of $50,000 plus the $150,000 puts me into the $200,000 income bracket and I have to pay income tax on all of that.   Income level of $200,000 puts me up to the 33% tax bracket (for 2010).   That gives me a total tax bill of $48,031.   This is $41,687 more than I would have paid without the conversion.   $41,687 taxes out of $150,000 from my IRA is an effective tax rate of 27.8%.   In order to convert the $150,000 IRA into a Roth IRA I'll have to pay 27.8% of the total in taxes.

I saved money in a 401k for years and avoided paying a 25% tax rate and then once I'd piled it all up into a savings account I decide to pay taxes at the rate of 27.8%.   Let me repeat that.  I avoided paying 25% tax and now I'm paying a 27.8% tax.  No. That does not make sense.

I don't happen to have $41,687 sitting in cash waiting to pay that tax bill.  So I use my IRA money to pay the taxes.   That leaves me with $108,313 in the Roth IRA after the fact.

Lets say I decide to retire early at age 62 and start drawing social security.   I'm frugal and can live off a relatively small amount.   My social security check is about $1,050 a month which gives me $12,600.   I then use the 4% rule to draw out of my IRA.    My social security and other income is low enough that I would not have to pay any income taxes on my social security.

The Roth IRA ended up with $108.313 which would give me $4,332 per year using the 4% rule.  But that money is TAX FREE!   YAY. 

On the other hand if I'd kept my $150,000 in the IRA and drawn out 4% of that I'd be taking out $6,000 a year and I'd have to pay taxes on that amount.  BOO!     Lets go back and use the handy tax calculator to figure out what my taxes on that $6,000 would have been.   Plug in $6,000 income, carry the 1, square root of pi, etc... the income tax on $6,000 for a single person is $0.


Lets sum up:    Over many years I put money into a 401k in order to avoid paying 25% tax rate.   Then I purposefully rolled that money into a Roth IRA and paid a 27.8% tax rate on it.   This left me with a $41,687 tax bill that cut my IRA funds from $150,000 to $108,313.    I purposefully chose to pay $41,687 in taxes.   THe end result is that I was able to avoid paying taxes on my retirement account withdrawals.   However if I had not done the roll over my tax liability would have been $0.    So in the name of avoiding taxes I gave the government $41,687 of my money in taxes in order to cut my retirement income from $6000 a year after taxes to $4,332 a year after taxes.   I did not make a good choice.

Obviously this is a contrived example.    I really hope there aren't people actually in this kind of situation but I fear there are a few folks doing exactly this.  If this person had done a couple things different then it wouldn't be as bad.   But the point of the story here is that Roth IRA conversions are not a great idea for everyone.   If you are considering a Roth IRA then you really need to figure out if its in your best interest and figure your tax impacts either way.

1 comment:

  1. There are additional considerations. In the year in which you convert, you may increase your taxable income to the point that you lose some deductions. Remember that certain deductions, like medical expenses, are based on a percentage of your income. Also, there are holding-period requirements, restrictions on converting inherited IRAs and other points to trip you up.
    Roth IRA conversion

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