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.

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