If you are in a 30% combined tax bracket (now and in the future) and invest $15,000 in a Roth, you’ll pay a $4,500 tax up front. If you successfully invest the $15,000 for 30 years at 10% compounded, you’ll have $261,741.

You would also have the same balance in a non-Roth account but would owe $78,522 (30%) in taxes. The argument has been that you can invest the $4,500 in up-front tax savings to cover the future taxes. Unfortunately, the $4,500 will be invested in taxable investments where your 10% return is reduced to 7% and will accumulate in 30 years to only $34,255 which is $44,267 short of the taxes owed.

I realize that this is simplified example and there are infinite variables, but am I missing something? Thanks.

I live in TX – no state income taxes. I will be in the top income tax bracket (Fed). I will max out my 401K contributions. I will receive some sort of match from my company up to a limit. I know that I won't retire anywhere with cheaper state tax than now since, as I mentioned, TX doesn't have state income taxes. So, in the future, my state income tax will either remain the same or go dramatically up. Also, I plan on investing 100% of the 401k in growth funds for most of the life of the 401k – hoping for solid gains.

I don't know if I will continue to bring in income after retirement. I can easily visualize it going either way…full retirement or self employed.

Did you think the Roth 401k is right for me?

Thank you.

I suppose it is still gambling to pay the taxes next year, because we don't know for sure we are going to stay in a high tax bracket and/or in a high tax state. But at least one of those two is likely. And, if we pay the tax in 2010 (you are correct, we won't wait for the higher taxes in 2011 and 2012 to make the payments), but things later go south for us financially, the money we "squandered" (in hindsight) on paying the conversion taxes would likely be toast in any event.

"A Roth 401(k) is also good for people who are already in the top tax bracket and expect to be there forever. If they don't see any chance of being in a lower tax bracket, prepaying tax now will lock in the tax rate so they won't have to worry about future tax increases."

By the way the options for paying the tax on Roth conversion (a) 100% of the conversion income reported as 2010 income OR (b) 50% of the conversion income reported as 2011 income and the other 50% reported as 2012 income. Given that the administration already proposed higher tax rates for your income level in 2011, you probably want to report the whole thing in 2010 and not risk a higher rate in 2011 and 2012.

For the extra credit, Kaye Thomas at Fairmark wrote:

"If you have enough wealth to be concerned about the estate tax, you should consider the benefit of a Roth IRA conversion in this connection. The estate tax applies to your total assets at death, including assets held in a traditional IRA or a Roth IRA. The difference is that the estate tax doesn't "notice" that the Roth IRA is bigger. So the amount of estate tax on a $500,000 IRA is the same whether it's a traditional IRA or a Roth IRA."

Advantages of Conversion

I am pleased to have found your blog and in particular this post. Although it is 1.5 years old, there are recent comments, so I am hoping you and/or others will respond to mine. The Roth conversion hype in the WSJ, etc, had me assuming it must be a no-brainer, but upon reading your post and this thread of comments, maybe it is a "brainer"?

We make a good living and taxes are by far our biggest expense. I agree with you that it is impossible to predict future tax rates, but easy to be assume that the federal and state governments will not be any less “broke” and thus likely will be doing everything they can to take wealth from anyone, anywhere they can find it in order to continue to hand out benefits and (most important) pay interest on the staggering debt, assuming we don't pull an Argentina on China.

I would love to get your opinion on whether we are the “exception” to your rule, and should pay the taxes in 2010 to convert an IRA to Roth.

I am 48; wife is 50. I have a traditional (pre-tax) IRA that has a current balance of around $500K. The IRA was funded entirely from rollovers from former 401k plans, plus a rollover from a cash balance (defined benefits) pension plan from a previous partnership. Since all three rollovers were entirely "before tax" money, we will get hit for income tax on the entire IRA, when distributed. I also have a current “traditional” (before tax) 401k that receives my personal contributions ($16.5K this year), plus my partnership profit sharing plan contributions (about $30K this year). We also have a cash balance (i.e., defined benefits) pension plan into which I contribute approx $50K a year into, all before tax. My wife (school teacher) has both a 403(b) plan and a 457 plan, and we max them out each year ($22K per plan, because she turned 50), again all before tax. We have no IRAs funded by after tax contributions. We have no Roth IRAs and no Roth 401ks.

For better and worse, we live in California. Since I am self-employed in a partnership, excluding unlimited SE taxes (Medicare), my incremental net tax rate is over 42% (we pay the extra 1% “Rob Reiner” tax at the margin). I don’t know how long we will keep working, but presumably at least another 10 years, and I am more likely to have a transitional retirement over many years, than an abrupt one. We will likely have enough pre-tax 401K and CB plan distributions (if we live long enough) to stay in a relatively high incremental tax bracket at the time the IRA distributions commence. This being the case, I presume that our eventual IRA distributions will be taxed at the highest marginal fed and state rates at the time. Tax rates always matter at the margins, and the "other brackets" you remind people about will already filled by our other income sources. It is possible (likely) we will move out of California to a low or no income tax state before any distributions are made from the IRA (and everything else), but I don’t know with any certainty whether this will happen.

If I understand correctly, we can "convert" the entire IRA to a Roth IRA by paying tax on the full $500K in 2010 (or split between 2010 and 2011). Assuming tax rates are the same for 2010 as they are for 2009, the conversion would cost us about $210K, and we would use existing (already-taxed) savings to pay the tax.

So, the question we are faced with is whether to pay the fed/CA state $210K next year to convert the IRA to Roth, or invest the $210k in something else. For simplification, I assume we would make identically-faring investments with the $210K as we do in the IRA account, and the exact same investments in the IRA account, regardless of whether we convert to Roth. To make the math easy, I assume we will withdraw all funds from the IRA at a point in the future when its value has exactly tripled (and that there are no age or other penalties involved by then). Same with the $210K alternative investment.

Option 1: do the Roth conversion and pay $210K tax in 2010. Result: $1500K “tax free” IRA balance at the time of distribution, no matter where we live.

Option 2: leave as “traditional” before tax IRA, and invest the $210K in same investments. Result: $1500K fully taxable IRA at time of distribution + $210K already taxed principle + $420K taxable gain on the investment = $1920K taxable plus $210K “tax free”. So, to break even or do better than the Roth conversion option 1, we would need to net at least [$1500K - $210K =] $1290K after tax from the $1920K taxable amount. This translates to an effective combined fed/state net marginal tax rate of no more than [(1920-1290)/1920] = 32.8% at the time of the distribution.

This may be possible IF we move to a low/no income tax state, but is extremely unlikely if we stay in California. One of your above commentators pointed out that capital gains taxes outside of the IRA are currently lower than income tax rates, it is entirely possible we will pay less than 32.8% on the $420K investment gains in option 2. Again, will depend on what state we live in. Plus, these investment gains are less than 25% of the total taxable amount.

Did I do the math wrong or make a flawed assumption? I believe your counseling that doing a Roth conversion is a bad idea is premised upon an assumption that people will not have any other significant sources of retirement income outside of the IRA/401k distributions in question. Maybe that is what you meant by the "millionaire" exception??

Speak to me, my friend. Is this a brainer or a no brainer? It seems to me the answer may come down to where you will live at the time of the distribution!

Extra credit: Estate planning nuances. Does it help or hurt your heirs if you die with undistributed traditional v. undistributed Roth accounts?

Of course, I am in that small majority that a Roth makes since for because I will end up in a much I higher tax bracket (active duty Navy in medical school.)