Financial Fundamentals: Why pay your taxes decades in advance?

To Roth or Not to Roth

By Thomas K. Brueckner, Strategic Asset Conservation

If you don’t have to pay your taxes for decades, why pay them all in one year now? The “Roth conversion” can be seen as beneficial with the assumption that taxes are certain to be higher in the future and are thus “on sale” today. While there are instances where a Roth conversion may make sense for certain people, for others, taking advantage of options that exist within a traditional IRA may be more advantageous. I believe it is important to give you context as well as updated, commonly held guidelines on whether and when you should consider converting some or all of an IRA account into a tax-free Roth IRA.

The Context: In any IRA account, the owner enjoys the benefits of what is known as “Triple Compounding.” You earn interest (or capital gains/dividends) on your principal, interest on your interest, and interest on the taxes you didn’t have to pay—money belonging to the IRS that was allowed to remain in the account, making you more money each year. Let’s not understate this benefit: The IRS doesn’t charge you interest on this “loan,” they merely promise to catch up with you later.

 And it’s actually even better than that. The IRS can’t make you take money out of the account taxably until April 1 of the year after the year in which you turn 70½. When you do so, the requirement is that you withdraw roughly 3.7 percent of your prior year-end value that first year, leaving the other 96.3 percent of your account to “triple compound” for another year. Here’s an example: If you had a $1 million IRA, and took out $37,000—withholding 22 percent of that ($8,140) for state and federal income taxes, you’d get to keep the remaining $28,860. But remember, the other $963,000 is allowed to “triple compound” for yet another year.

The Argument: The proponent of Roth conversion argues that in order to avoid the $8,140 in taxes (less than 1 percent of the account value) and deny yourself the ongoing benefit of triple compounding over the remaining 15 to 20 years of your life, you should instead pay your taxes on the entirety of the account, as much as 20 to 30 years before they are due. That, by the way, would result in an immediate loss of roughly one-third of the account ($340,000)—money on which you’ll never earn free interest again. Ah, but “the good news” is that from that point forward, your new Roth IRA would grow tax free, not just during your lifetime, but during that of your heirs as well. Paying $340,000 in taxes just to avoid paying $8,140 in taxes had better yield some large benefit for the entire exercise to have been worth it.

When and Whether: So when does Roth conversion make sense and under what circumstances?

• When you don’t or won’t need the money for your own retirement.

• When you’d rather pay income taxes on it at 28 percent to 35 percent than have your heirs pay estate taxes on it at up to 55 percent (only applicable to a net worth in excess of $10 million).

• When you have enough funds outside of the IRA to pay the income taxes with, ideally spread out over several years.

• When the IRA owner is under 58 years of age.

• When you are certain that you’ll be in a substantially higher tax bracket once retired than the one you’re in during the years you intend to convert.

• When you are certain that your heirs won’t be tempted to touch the money for at least 10 to 25 years, thus giving the potential for the tax-free growth an opportunity to prove itself.

It’s this last caveat that is often the deal breaker. Seldom will one’s heirs exercise such restraint when needs arise (college tuition, mortgage payoff or a job loss after 50) or opportunities such as buying a vacation property or an exotic car present themselves. An account that grows tax free “forever” only does its owner good if they don’t spend most of it before forever arrives.

“But your mom and dad would have wanted us to enjoy this, honey.” For this, you paid $340,000 in taxes decades before they were due? Sadly, in most cases, yes.

Thomas K. Brueckner, CLTC, is president/CEO of Strategic Asset Conservation in Scottsdale, a conservative wealth management firm with clients in 18 states and six countries. He is a 2011 Advisor of the Year national finalist, a radio talk show host, and a mentor to other advisors nationally. Contact: go2knight.com.