Roth IRA Conversions: “What you need to know but may not have known to ask…”

“Psychological” Push & Marginal Tax rate (MTR)

“Behavioral Finance or Behavioral Economics”provides another reason for participants to consider conversion of pre-tax assets to a Roth IRA.  Wikipedia explains these fields of study as follows:

“Behavioral finance and behavioral economics are closely related fields which apply scientific research on human and social cognitive and emotional biases to better understand economic decisions and how they affect market prices, returns and the allocation of resources. The fields are primarily concerned with the rationality, or lack thereof, of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory.” Learn more

Most of us realize that an important factor in determining the optimal tax environment to save for retirement is based on one’s tax rate when contributing to a retirement account versus one’s tax rate when receiving distributions from it.  By tax rate, we mean one’s marginal tax rate (MTR), or the tax rate paid on the last dollars one earns in a particular tax year (i.e., the tax rate that applies to one’s highest level of taxable income for the year).

Most of us also understand that the Roth option is generally beneficial to participants whose marginal tax rate (MTR) is lower when contributing versus their MTR when receiving distributions in retirement, since taxes on contributions were paid at a lower rate.  Conversely, the pre-tax option is generally beneficial to participants whose MTR is higher when contributing versus receiving distributions in retirement, since taxes on distributions are paid at a lower rate.  Learn moreabout MTRs

The detailed information and analysis in Save to Retire: Pre-tax, After-tax or Roth?; and Roth 401(k) Case Studiesdemonstrate that it costs us more to contribute the same amount to a Roth versus a pre-tax account (the applicable income tax); however, we effectively save more.  Therefore, since most of us simply do not save what we gain by contributing to pre-tax accounts (the “tax savings” from the deduction), Roth options (IRA, 401(k), conversion) provide a “psychological” push to save more for retirement.

CommentaryThis article and knowledgebase validate that reasonable increases or decreases in one’s MTR will impact the projected differential between saving in the Roth’s unique tax-free environment versus a pre-tax account’s tax-deferred environment.  They further validate that under certain circumstances (“it’s all about time”), the Roth provides a more favorable outcome if the individual’s MTR (and his/her beneficiaries) remains static, increases or decreases.

While others who write on this subject may outline the complex mathematics required to solve this puzzle (for example, if you are “x” years old when you start to save, your MTR changes by “y” percent, you receive distributions starting when you are “z” years old, and you receive the distributions over “yadda yadda” years, then the Roth is preferred, or not); but…  After the numbers are crunched every conceivable way, it’s the differential in the rates of return on investments in the Roth environment versus anywhere else that is the most significant factor in this analysis.  If one assumes comparable risk factors attributable to the selected investments, a taxable side fund cannot perform as well as the tax-free Roth, because…

The Roth’s unique tax-free environment is the only one in which a conservative investor might earn 5.5-6% in a taxable bond versus 4-4.5% in a tax-free bond (assumes the taxable and tax-free bonds have a comparable level of risk); or in which an individual can invest in other taxable assets absent any taxes on short or long-term gains.

The bottom line  In the debate over “to convert or not to convert,” the skeptics say: “future tax rates are uncertain.” As an advocate, I say: “consider that the outcome of converting only a portion of one’s pre-tax assets to Roth will have little, if any, impact on most regardless of future tax rates [especially high net worth individuals].” The skeptics then counter by saying: “One should never pass up an opportunity to save taxes.” I say: “consider that most individuals simply do not save the proceeds of the tax deduction.”

Regardless of how you save for retirement… it’s typically best to spend down your after-tax retirement savings first, your pre-tax assets next, and your Roth assets last.

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Copyright © 2009 Barry R. Milberg   All Rights Reserved

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