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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