The Best Article Ever On Roth Conversions

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Hi Josh,

I’ve attached a quick / short analysis that pits a Roth retirement approach versus a pre-tax 401 approach. I’m a bit surprised at the outcome.

Here are the assumptions.
1. Married employee in both cases.
2. An employee who is 55 years old invests $25,000 into the company’s retirement account.
a. $19,000 limit, plus
b. $6,000 over 50 catch-up
3. One employee pays the taxes up-front and invests the net of $16,088 into a Roth.
4. Another employee avoids / defers the taxes and invests the entire $25,000 into a 401.
5. Both investments earn the same return.
6. After 10 years the 401 will be converted over to a Roth.
c. This conversion signals the retirement of the individual in a non-income tax state which is one difference between the two approaches. Their working career was in an income taxed state while they both retire in a non-taxed state.
7. The analysis is taxing the 401 at the same tax-rate level minus any state income tax. If you execute your conversions at a lower tax rate, say 12% the results could even be more divergent.(emphasis mine).
d. Also, the reason I’ve taxed the entire Roth amount at 22% Federal is because that is the bracket the employee’s income tops out at. For the retiree when any Roth conversions is likely to take place the taxes would be on a stepped approach topping out at possible 12%. You will find this analysis on the Sheet 2.

What am I missing here? If this analysis is correct it seems advantageous to invest in the 401 and convert to a Roth when you are either in a lower tax bracket, in a non-income tax state or both.

SUMMARY

Allright, so what this guy from high tax Connecticut has calculated is that it doesn’t make ANY SENSE to contribute to a Roth 401k WHILE you’re working in the high tax state if you plan on moving to a low tax state.

In fact, everything else being equal, contributing to a Roth 401k in this example cost you about $2,400 in total net worth. Even worse, once you retire and have less taxable income, and THEN do Roth conversions in a low tax state, you’re $7,000 RICHER than if you did the Roth 401k while working and living in that high tax state.

This further proves the benefits of actual tax planning and projection.. If your tax bracket will be HIGHER in the future, you convert NOW. If your tax bracket will be LOWER in the future, you convert THEN.

Our friend here provides the perfect illustration. He should unequivocally WAIT to do any Roth contributions/conversions until his tax situation changes for the better.

Now, be advised, I know there are going to be some that say “I won’t do any Roth conversions ever because my tax bracket will be the same or lower than it is today.” To which I say, “are you married?” If the answer is YES, than your tax bracket will certainly be higher in the future, do to nothing more than the tax code difference of married filing jointly vs. single taxpayer.

If you’ve retired and are married, your tax bracket will probably be higher in the future, maybe even much higher. However, if you’re working, towards the end of your career and thus making good money, it’s probably wise to wait to do any Roth’s until you separate from service, especially if you’re in a high taxed state.

Wait until the income stops and you skedaddle from those confiscatory states and then you can shout “ROTH ALL THE WAY!” loud and proud. Your previous governor will hear your cries of freedom and will shake his fist at the sky saying “Damn you Bill Roth!!! You robbed me of tax dollars!”

Even though written in 2007 this is the best article I ever read about Roth Conversions. Changed EVERYTHING for how I do financial planning.

Highly recommend you read it too.

 

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