VictoriaF wrote:Here is what I meant:
- State-1: You have $4,000 in a Traditional IRA and $1,000 in a taxable account. Total assets = $5,000, of which $4,000 are of poorer quality, because they will be taxed on withdrawal.
- State transition: Convert Traditional IRA into Roth IRA and spend $1,000 of taxable money to pay taxes on the conversion.
- State-2: You have $4,000 in a Roth IRA and $0 in a taxable account. Total assets = $4,000, i.e., less than before. But they are of higher quality, because they are not taxable.
I should have used the term net
assets rather than assets. Under the 25% tax criteria State-1 would have total net assets of only $4,000, since $1,000 belongs to the government.
Larry pointed out that in this situation one could consider the TIRA to consist of two tax-free
accounts, one ($1,000) belonging to the government, and the second one ($3,000) belonging to you. The impact of the conversion would be to replace the government's tax-free $1,000 account with a $1,000 tax-free account of your own. So you don"t "spend" $1,000 to make the conversion, you just "transfer" $1,000 into the Roth.
I was a little concerned that some might assume that they would lose net assets by making a conversion. (They of course could lose or gain net asset value if it turns out that they could have withdrawn from the TIRA at a later date when in a lower of higher tax bracket).
I agree that the net
assets (in the context you and Larry use the term here) have not changed, i.e., they are $4,000 in both state-1 and state-2 in my example. However, do the taxing authorities look at the assets the same way? For example:
- Inheritance is taxed above a certain asset level. Does the computation of assets take into account that some of them (401(k), T-IRA) have imputed tax whereas others (Roth-IRA) don't?
- When people's assets are considered for the purpose of Medicare, Medicaid, or subsidized housing eligibility, are the distinctions made between taxable and tax-free assets? (Actually, this may not be a great example, because near the poverty level taxes are negligible anyway.)
Are there other cases of means-testing that target assets (rather than income)? Are tax-deferred and tax-free assets treated differently in these cases?
To summarize my thinking about hypothetical
future taxation of Roth-IRA:
- The easiest thing to tax would be only future
Roth-IRA earnings; that is after
some currently-undefined future date when the law may be changed.
- Going back in time to collect past Roth-IRA earning, perhaps, is possible but is very messy and is bound to be highly
- Most Roth-IRA holders are not rich; the affluent are excluded from the Roth IRA contribution/conversion limits (until 2010 that is). And so taxing middle class here would be difficult to defend.
- Means testing, I think
, is usually applied to income rather than assets. The obvious example is taxation of the Social Security benefits. In this context, Roth IRA provides a huge advantage.
- Means testing of assets is more difficult. But if it is used, either T-IRA and Roth-IRA will be equivalent, or Roth-IRA may be preferrable because the taxing authorities may ignore the difference in tax liabilities.
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