Roth: Too Good To Be True?

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Roth: Too Good To Be True?

Post by pkcrafter » Sun Dec 06, 2009 1:53 pm

Roth conversions--

While the Roth conversion may be a great idea for some investors, clearly it benefits the government now. Ric Edelman does not even recommend conversions. No comment on Edelman, but consider this.

It is in large part because of this rather stunning aspect of the Roth IRA provision that it ultimately would carry a significant cost. The Joint Committee on Taxation’s official cost estimate of the conference agreement shows that this provision will raise about $6.4 billion through 2015. But the Urban Institute-Brookings Institution Tax Policy Center, while concurring with the Joint Tax Committee’s estimate for the period through 2015, projects that the provision will lose $100 billion through 2049.


http://www.cbpp.org/cms/?fa=view&id=159

Consider the possibility that Roths will be taxed in some way at some future time.


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Post by baw703916 » Sun Dec 06, 2009 2:06 pm

No mystery. The Roth 2010 provision was put in a tax bill in 2001, to make the bill budget neutral over a 10 year span (the operating ground rules at that time). By putting in a Roth conversion at any income level in the tenth year, the expectation is that people who couldn't otherwise convert would do so and pay more taxes in 2010. Obviously money that is converted to Roths in 2010 won't be taxable down the road as it would have been had it stayed in traditional IRAs.

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Post by AzRunner » Sun Dec 06, 2009 2:28 pm

Regarding Roth Conversions you have to look at your own situation. The advantages of 2010 are that you are not curtailed from making a conversion even if your gross income is greater than $100K and you can delay the tax bill and split the payment between 2011 and 2012.

That said, I would not pay taxes early unless I was paying at a lower marginal rate than anticipated under a Required Minimum Distribution down the road.

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Post by pkcrafter » Sun Dec 06, 2009 2:28 pm

baw wrote:
Obviously money that is converted to Roths in 2010 won't be taxable down the road as it would have been had it stayed in traditional IRAs.

Well, the 'obvious it won't be taxed' is the issue I'm wondering about.


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Re: Roth

Post by AzRunner » Sun Dec 06, 2009 2:33 pm

pkcrafter wrote:baw wrote:
Obviously money that is converted to Roths in 2010 won't be taxable down the road as it would have been had it stayed in traditional IRAs.

Well, the 'obvious it won't be taxed' is the issue I'm wondering about.


Paul


Speculation on future tax law changes can lead to analysis paralysis. Even if one is fearful of a value added tax or some other back door taxing of Roth withdrawals, it may make sense to diversify your tax situation by converting a portion of a traditional IRA to a Roth, especially if you have a large IRA.

Norm

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Post by pkcrafter » Sun Dec 06, 2009 2:52 pm

Norm wrote:
Speculation on future tax law changes can lead to analysis paralysis. Even if one is fearful of a value added tax or some other back door taxing of Roth withdrawals, it may make sense to diversify your tax situation by converting a portion of a traditional IRA to a Roth, especially if you have a large IRA.

Thanks Norm, I agree with your conclusion.


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Re: Roth

Post by jeffyscott » Sun Dec 06, 2009 3:34 pm

AzRunner wrote:Even if one is fearful of a value added tax or some other back door taxing of Roth withdrawals...


If a VAT comes into being, how would one be any better off with a traditional IRA instead of a Roth? Aside from cuts in income tax rates, which I think are pretty unlikely, is there any reasonable scenario where a tax law change would make one better off with the TIRA than the Roth.
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Post by jjkthunder » Sun Dec 06, 2009 4:42 pm

Lets say there's a possibility that ROTH might be taxed after 2015 or farther in the future.

I'm wondering if a person goes beyond the break even point in his ROTH to take the gains out???

In my case I am close to recovering the tax I paid(from a taxable account) on my conversions since 2004. I have been able to convert within the 15% tax bracket the last five years and expect to convert more in the 15% bracket until I'm not able too anymore. For me I also am paying an additional 7% Wisconsin state tax on my conersions.

That being said when I'm beyond the 22% break even point, possibly I should start taking out only the gains over the total ROTH conversion.
I'm thinking if IRS does come up with taxing it would only be on the gains and not on the conversion amount. As of this year I have converted a total of $216K .

Any thoughts on other Bogleheads part????
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Post by Lbill » Sun Dec 06, 2009 5:10 pm

If a VAT is enacted, then you will pay tax every time you spend your money no matter what the source, correct? TIRA, IRA, Taxable - what's the diff? With a Roth conversion I'm at least hoping that I can reduce the income tax part of Uncle Sammy's cut or I wouldn't be doing it. I can't do anything about a VAT anyhow.
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Re: Roth

Post by FinanceGeek » Sun Dec 06, 2009 5:10 pm

jeffyscott wrote:
AzRunner wrote:Even if one is fearful of a value added tax or some other back door taxing of Roth withdrawals...


If a VAT comes into being, how would one be any better off with a traditional IRA instead of a Roth? Aside from cuts in income tax rates, which I think are pretty unlikely, is there any reasonable scenario where a tax law change would make one better off with the TIRA than the Roth.


The devil is always in the details. Suppose a consumption tax based system came into being which completely replaced the income tax. I'd feel pretty silly having paid income taxes to convert to Roth and now have to pay VAT on the proceeds wouldn't I? Better to have not converted. Of course this all assumes a very implausible shift away from taxing income, especially so-called "unearned" income.

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Post by Lbill » Sun Dec 06, 2009 5:19 pm

The devil is always in the details. Suppose a consumption tax based system came into being which completely replaced the income tax.

Being one of those souls who has decided to take the pain of a tax hit now to do Roth conversions, these are the kinds of things one worries about. But I finally decided that they wouldn't dare mess with all of us senior citizens by reneging on the Roth. Oh, they'll get us, but they are more likely to do something like a VAT that doesn't target only Roth-ers.
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Post by the intruder » Sun Dec 06, 2009 5:40 pm

Lbill wrote:
The devil is always in the details. Suppose a consumption tax based system came into being which completely replaced the income tax.

Being one of those souls who has decided to take the pain of a tax hit now to do Roth conversions, these are the kinds of things one worries about. But I finally decided that they wouldn't dare mess with all of us senior citizens by reneging on the Roth. Oh, they'll get us, but they are more likely to do something like a VAT that doesn't target only Roth-ers.


What make you think Congress wouldn't 'mess' with senior citizens again? After all 26 yers ago Congress messed with social security and began taxing benefits. At the time the excuse was that less than 10% of SS recipients would pay taxes on their benefits. Today its over 25% because the income tax thresholds are not linked to inflation. There is nothing that prevents a future Congress from taxing Roth IRA for a similar group of high income earners, say anyone with AGI over $100,000.

A VAT is a fictional option because it is a regressive tax on the lower 80% of taxpayers who pay little or no income tax. 62M taxpayers have no taxable income and another 26M are in the 10% bracket (out of total 170M taxpayers in 2008). What incentive is there for a Democratic congress to tax their political base?

Its easier for Congress to raise taxes on the higher wage earners for example the 7.6M of taxpayers in the 28% or higher bracket.
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Re: Roth: Too Good To Be True?

Post by digit8 » Sun Dec 06, 2009 5:44 pm

pkcrafter wrote:Consider the possibility that Roths will be taxed in some way at some future time.


Then the Roth convertors look like fools.

Consider that TIRA's and Roths continue to be taxed in the way they are now- but the tax rate increases so much that even in retirement, 30 years hence, one is paying 20% more than they do now. The Roth converters look like geniuses.

Either case, though, only applies to those who go all-or-nothing. Placing all ones money on a guess about future tax law over the long haul is more of a sucker bet then individual stocks.

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Post by Lbill » Sun Dec 06, 2009 5:45 pm

intruder - you're probably right, but let me enjoy my fantasy long enough to get my Roth conversions completed. :shock:
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Post by the intruder » Sun Dec 06, 2009 6:21 pm

Lbill wrote:intruder - you're probably right, but let me enjoy my fantasy long enough to get my Roth conversions completed. :shock:


I hope you will get a tax benefit from the conversions.

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Re: Roth: Too Good To Be True?

Post by VictoriaF » Sun Dec 06, 2009 7:36 pm

pkcrafter wrote:Consider the possibility that Roths will be taxed in some way at some future time.

Paul

Paul,

Let's assume that this possibility becomes a reality, and let's consider the venues for taxing Roth IRA. One is a consumption tax. Another is taxing Roth IRA itself.

Say, you have some amount X in a traditional IRA. In 2010 you convert it into Roth and pay 28% in taxes, or 0.28 x X.

For some time (e.g., 10 years), your Roth IRA accumulates tax-free to (X + N). Note that nobody tracks your Roth IRA earnings, and this entire amount is available for tax-free withdrawals.

Then, 10 years from now, a change in the legislation makes Roth IRA taxable. The only thing they can tax is the earnings on (X + N). Will that be annoying? Yes. Will that be a travesty? No. After all, you did gain N in tax-free dollars that would not be possible without the conversion.

Roth IRA will simply become equivalent to a traditional IRA with after-tax contributions.

Victoria
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Post by Lbill » Sun Dec 06, 2009 8:08 pm

For some time (e.g., 10 years), your Roth IRA accumulates tax-free to (X + N). Note that nobody tracks your Roth IRA earnings, and this entire amount is available for tax-free withdrawals.

Victoria - I guess you're correct, in that no IRS reporting forms are generated for Roths as far as I know. But that doesn't mean that they couldn't be slapped together retroactively does it? Once upon a time I lived in Toronto as a Canadian resident but a U.S. citizen. After a couple of years, the U.S. changed it's taxation rules retroactively as they applied to foreign residents. They placed the burden on me to report all the newly required information and pay the appropriate tax for all previous years. So, under the obscure and undefined threat that someday the IRS would track me down, I had to generate the required information and comply. I imagine they could do the same in order to apply a retroactive tax to Roth earnings as well and it would be up to you and I to somehow comply and hope that if we are makin' things up they won't find out about it. They could also require your Roth custodian to produce forms showing past earnings, correct? Don't know how they would do it, but they'd probably find a way.
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Post by VictoriaF » Sun Dec 06, 2009 8:55 pm

Lbill wrote:
For some time (e.g., 10 years), your Roth IRA accumulates tax-free to (X + N). Note that nobody tracks your Roth IRA earnings, and this entire amount is available for tax-free withdrawals.

Victoria - I guess you're correct, in that no IRS reporting forms are generated for Roths as far as I know. But that doesn't mean that they couldn't be slapped together retroactively does it? Once upon a time I lived in Toronto as a Canadian resident but a U.S. citizen. After a couple of years, the U.S. changed it's taxation rules retroactively as they applied to foreign residents. They placed the burden on me to report all the newly required information and pay the appropriate tax for all previous years. So, under the obscure and undefined threat that someday the IRS would track me down, I had to generate the required information and comply. I imagine they could do the same in order to apply a retroactive tax to Roth earnings as well and it would be up to you and I to somehow comply and hope that if we are makin' things up they won't find out about it. They could also require your Roth custodian to produce forms showing past earnings, correct? Don't know how they would do it, but they'd probably find a way.

Lbill,

Theoretically, they can do anything. In practice, your suggested scenario would mean:
- impact on many (local) U.S. citizens who, as a group, are not as sophisticated as expatriates
- tracing multiple IRA custodians -- let me coin a term "IRA laundering" ;)
- backlash much greater than simply taxing future earnings.

I'd bet that if Roth IRA is ever taxed, it would be in a more straight-forward way. And if taxing just future interest does not bring significant enough revenues, they may leave Roth IRA along and increase other taxes.

Victoria
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Post by Lbill » Sun Dec 06, 2009 9:06 pm

Victoria- I think you're probably right, but who knows? With all that potential tax money hanging on low-lying limbs and the absolute necessity of collecting more tax monies from them that have it, they'll be burning the lights in DC trying to figure out how to pick some of that fruit.
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Post by drewhaa » Sun Dec 06, 2009 10:11 pm

Isn't a gradual decline in income tax rates, coupled with an increase in consumption (sales) tax rates the more-likely fear for the Roth holder?

Or for all IRA holders: the government exempts a certain amount of interest/dividend/capital gains income per year?

Two thought experiment type questions for everyone:

1. How would the implementation of a 5 or 10 percent national sales tax change your investment decisions, if at all?

2. If the first $15K of combined interest/dividend/capital gains income was exempted from federal income tax, how would this effect you investing behavior, including placement in tax-advantaged space?

Two things seem certain about taxes: 1. They will change; and 2. I have little control over them.

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Post by pkcrafter » Sun Dec 06, 2009 10:12 pm

Everyone is aware that there is currently a proposal in congress to tax market trades at 0.25%? Hmmm........ Tax Roth? Definitely a possibility, but I suspect it will won't happen for several years. Anyway, if you are planning a conversion, be sure to do the numbers and leave some wiggle room.


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Post by VictoriaF » Sun Dec 06, 2009 10:22 pm

drewhaa wrote:Isn't a gradual decline in income tax rates, coupled with an increase in consumption (sales) tax rates the more-likely fear for the Roth holder?

Or for all IRA holders: the government exempts a certain amount of interest/dividend/capital gains income per year?

Two thought experiment type questions for everyone:

1. How would the implementation of a 5 or 10 percent national sales tax change your investment decisions, if at all?

I will reduce my consumption from its already relatively low levels. For the society some implications will be as follows:
- Reduced consumer spending (as in my case).
- Regressive taxation (mentioned above in this thread).
- Increase in bartering, garage sales, and alike.
- Increase in theft and robberies.
- Increase in contraband.
- Increase in white-color crimes such as shadow inventory.

drewhaa wrote:2. If the first $15K of combined interest/dividend/capital gains income was exempted from federal income tax, how would this effect you investing behavior, including placement in tax-advantaged space?

Two things seem certain about taxes: 1. They will change; and 2. I have little control over them.


I agree about little control over taxes. But I do like to consider likelihoods of various scenarios.

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Post by the intruder » Sun Dec 06, 2009 10:24 pm

Lbill wrote:
For some time (e.g., 10 years), your Roth IRA accumulates tax-free to (X + N). Note that nobody tracks your Roth IRA earnings, and this entire amount is available for tax-free withdrawals.

Victoria - I guess you're correct, in that no IRS reporting forms are generated for Roths as far as I know. But that doesn't mean that they couldn't be slapped together retroactively does it? Once upon a time I lived in Toronto as a Canadian resident but a U.S. citizen. After a couple of years, the U.S. changed it's taxation rules retroactively as they applied to foreign residents. They placed the burden on me to report all the newly required information and pay the appropriate tax for all previous years. So, under the obscure and undefined threat that someday the IRS would track me down, I had to generate the required information and comply. I imagine they could do the same in order to apply a retroactive tax to Roth earnings as well and it would be up to you and I to somehow comply and hope that if we are makin' things up they won't find out about it. They could also require your Roth custodian to produce forms showing past earnings, correct? Don't know how they would do it, but they'd probably find a way.


Roth IRA contributions for each year are reported on IRS form 5498 (box 10) and conversions are reported on Box 3. The earnings are the difference between the contributions plus coversions and the account balance as of each Dec 31. As it is the contributions are tracked presently in case the owner has a loss on the Roth IRA where the total contributions to all Roth IRAs exceed the amount of the distributions which allows the owner to claim the loss as a miscellaneous deduction.
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Re: Roth: Too Good To Be True?

Post by eurowizard » Sun Dec 06, 2009 10:33 pm

The Joint Committee on Taxation’s official cost estimate of the conference agreement shows that this provision will raise about $6.4 billion through 2015. But the Urban Institute-Brookings Institution Tax Policy Center, while concurring with the Joint Tax Committee’s estimate for the period through 2015, projects that the provision will lose $100 billion through 2049.


Math Fail!

$100B in 2049 at a discount rate of 7% (which would be inflation rate of 3% plus a 30 year treasury rate of 4%) has a present value of about $7B

Assuming inflation rises to 4% then this value drops below $5B.

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Re: Roth: Too Good To Be True?

Post by the intruder » Sun Dec 06, 2009 11:20 pm

eurowizard wrote:
The Joint Committee on Taxation’s official cost estimate of the conference agreement shows that this provision will raise about $6.4 billion through 2015. But the Urban Institute-Brookings Institution Tax Policy Center, while concurring with the Joint Tax Committee’s estimate for the period through 2015, projects that the provision will lose $100 billion through 2049.


Math Fail!

$100B in 2049 at a discount rate of 7% (which would be inflation rate of 3% plus a 30 year treasury rate of 4%) has a present value of about $7B

Assuming inflation rises to 4% then this value drops below $5B.


Under law, tax legislation estimates of revenue gains or losses are limited to 10 years from the date the legislation is effective. Projections of revenue losses over 40 years are are not creditible because no one can predict the state of the economy over such a long period. Besides, Congress can use any excuse to raise revenue by taxing Roth IRA earnings.

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Post by Abciximab » Mon Dec 07, 2009 12:49 am

Judging by the federal deficits we may be facing in the future, it seems that taxation of Roth IRAs could be very possible. But then again, who knows? After all, most of us have 401(k)s that serve as a hedge of sorts: pay the tax up front with a Roth and pay the taxes later with a 401(k).
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Post by kevincohen » Mon Dec 07, 2009 1:27 am

It would be very easy for Congress to impose back door financial penalties on Roth IRAs that would have the same monetary effect as a tax but without being a tax.

For example, they could impose a means test to determine the amount of Social Security or Medicare benefits you receive, and they could include Roth IRA distributions as part of the means test.

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Post by jeffyscott » Mon Dec 07, 2009 8:15 am

If Roth IRA distributions were to have some impact on SS, it would be an equally simple matter to take all your money out prior to applying for SS.

Now were I someone in a position to convert during this window of opportunity, I most likely would not, simply because this special window is for those with incomes of over $100K and the Federal taxes will therefore be at least 25%. I don't have a TIRA, but I am figuring on someday maybe converting 401K/457/403(b) retirement accounts (during early retirement prior to SS) to the extent I can do so at a 15% tax rate. I'd not be inclined to do it at a higher tax rate as I really don't expect to have a retirement income level that will put me in the 25% bracket and am quite certain I'll not be in a higher one.

(In addition, I read in the newspaper this weekend that my state did not adopt the federal rules for this, anyway. So there apparently are penalties that would apply on the state level. I'd be surprised if this is not also an issue in some other states.)
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Post by Wagnerjb » Mon Dec 07, 2009 8:16 am

kevincohen wrote:It would be very easy for Congress to impose back door financial penalties on Roth IRAs that would have the same monetary effect as a tax but without being a tax.

For example, they could impose a means test to determine the amount of Social Security or Medicare benefits you receive, and they could include Roth IRA distributions as part of the means test.


I suspect the exact kind of scenario you suggest is a very real risk, but more for the higher income folks. It doesn't take an overhaul of our tax system or a great deal of imagination to see what might happen to a Roth in the future.

Best wishes.
Andy

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Post by matt » Mon Dec 07, 2009 1:56 pm

Ric Edelman does not even recommend conversions.


Is it just a coincidence that Edelman recommends using a traditional IRA and maximizing your home loan value, two situations that will leave more money in his clients' accounts to manage?

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Post by ResNullius » Mon Dec 07, 2009 2:26 pm

I kind of doubt that a Dem Congress will leave this in place for long, given the government's need for huge supplies of new revenue. I figured it would be repealed this year, possibly next, but who knows. Down the road, I think it's a safe bet that those with significant wealth can count on getting nailed from all sides, including the taxation of Roth withdrawals. It might be called something else, like a new AMT, but I think it will happen. This truly makes me question the wisdom of converting, particularly if you're upper income status will remain even after retirement and after the conversion. Just my two cents.

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Post by Wagnerjb » Mon Dec 07, 2009 5:18 pm

ResNullius wrote: This truly makes me question the wisdom of converting, particularly if you're upper income status will remain even after retirement and after the conversion. Just my two cents.


I probably fit that description, and have zero interest in converting. But that doesn't mean that everybody who is newly eligible in 2010 shouldn't convert. The guy (or family) who is 30 years old and making $110,000 might see the conversion as sensible.

Best wishes.
Andy

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Post by VictoriaF » Mon Dec 07, 2009 6:03 pm

Wagnerjb wrote:
kevincohen wrote:It would be very easy for Congress to impose back door financial penalties on Roth IRAs that would have the same monetary effect as a tax but without being a tax.

For example, they could impose a means test to determine the amount of Social Security or Medicare benefits you receive, and they could include Roth IRA distributions as part of the means test.


I suspect the exact kind of scenario you suggest is a very real risk, but more for the higher income folks. It doesn't take an overhaul of our tax system or a great deal of imagination to see what might happen to a Roth in the future.

Best wishes.

How is means testing for Roth IRA worse than means testing for Traditional IRA? If anything, this may be to the Roth advantage.

If one pays non-IRA money to convert to Roth, the total amount of one's assets goes down, while the quality of these assets increases (because they are not taxable).

Victoria
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Post by the intruder » Mon Dec 07, 2009 8:36 pm

VictoriaF wrote:
Wagnerjb wrote:
kevincohen wrote:It would be very easy for Congress to impose back door financial penalties on Roth IRAs that would have the same monetary effect as a tax but without being a tax.

For example, they could impose a means test to determine the amount of Social Security or Medicare benefits you receive, and they could include Roth IRA distributions as part of the means test.


I suspect the exact kind of scenario you suggest is a very real risk, but more for the higher income folks. It doesn't take an overhaul of our tax system or a great deal of imagination to see what might happen to a Roth in the future.

Best wishes.

How is means testing for Roth IRA worse than means testing for Traditional IRA? If anything, this may be to the Roth advantage.

If one pays non-IRA money to convert to Roth, the total amount of one's assets goes down, while the quality of these assets increases (because they are not taxable).

Victoria


While Roths are not subject to income tax they are subject to estate tax which if allowed to compound over a long enough period could result in estate taxation if the entire estate exceeds $3.5M. Some states (e.g. NY) tax estates which exceed $1M in addition to the federal estate tax. All thie means is that taxpayers in the higher brackets and assets have to do a very careful evaluation of a Roth conversion.

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Post by Wagnerjb » Mon Dec 07, 2009 8:39 pm

VictoriaF wrote:How is means testing for Roth IRA worse than means testing for Traditional IRA? If anything, this may be to the Roth advantage.

If one pays non-IRA money to convert to Roth, the total amount of one's assets goes down, while the quality of these assets increases (because they are not taxable).

Victoria


Victoria: maybe I don't understand your question, but I will take a stab at it anyway. Means testing for a Roth IRA means you get to pay taxes a second time (when you withdraw). I am not sure what means testing for a Traditional IRA means, but since you never paid tax on the assets I would think anything short of paying taxes twice would make the decision favor the Traditional IRA.

Best wishes.
Andy

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Post by Bob's not my name » Mon Dec 07, 2009 8:55 pm

the intruder wrote:While Roths are not subject to income tax they are subject to estate tax which if allowed to compound over a long enough period could result in estate taxation if the entire estate exceeds $3.5M. Some states (e.g. NY) tax estates which exceed $1M in addition to the federal estate tax. All thie means is that taxpayers in the higher brackets and assets have to do a very careful evaluation of a Roth conversion.

How do you figure? Converting means paying income taxes now and thereby reducing the estate. For example, if you have a $1.1M estate that includes a $0.3M tIRA, you can convert and pay the income tax, and now your estate is <$1M.
That's not the only advantage of conversion for estate planning. Others are:
1. Elderly persons, even wealthy-ish ones, are often in low brackets due to medical deductions vs. their children, who may be in peak earning years.
2. Elimination of RMD's allows preservation of the tax-advantaged IRA.
3. Paying tax with non-IRA assets effectively increases the value of the inherited IRA (that is, you shift from taxable to tax-advantaged).
Of course these advantages don't all apply in every situation. I'm planning to do a Roth conversion for an elderly grantor, so I'm interested in any flaw in this logic.

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Post by DickBenson » Mon Dec 07, 2009 9:00 pm

VictoriaF wrote:If one pays non-IRA money to convert to Roth, the total amount of one's assets goes down, while the quality of these assets increases (because they are not taxable).


I think you meant to say that "the total amount of one"s assets does NOT go down.

Example: tax bracket 25%
.
$4,000 IRA, non-IRA funds $1,000, asset value $4,000 (gov't debt of $1000).
$4,000 Roth, $0 non-asset fund, asset value still $4,000.

But the quality of your investments does increase. You now have $1,000 generating tax-free income, rather than tax-deferred.

Dick

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Post by Lbill » Mon Dec 07, 2009 9:47 pm

intruder wrote:
While Roths are not subject to income tax they are subject to estate tax which if allowed to compound over a long enough period could result in estate taxation if the entire estate exceeds $3.5M.

I didn't know this was true. I thought that a Roth passes tax-free to the beneficiary on the death of the owner, just as a TIRA does. As a matter of fact, Ed Slott advises people to convert a TIRA to a Roth and pay the tax out of their taxable funds (including the TIRA) in order to thereby reduce the size of their taxable estate.
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VictoriaF
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Post by VictoriaF » Mon Dec 07, 2009 9:47 pm

DickBenson wrote:
VictoriaF wrote:If one pays non-IRA money to convert to Roth, the total amount of one's assets goes down, while the quality of these assets increases (because they are not taxable).


I think you meant to say that "the total amount of one"s assets does NOT go down.

Example: tax bracket 25%
.
$4,000 IRA, non-IRA funds $1,000, asset value $4,000 (gov't debt of $1000).
$4,000 Roth, $0 non-asset fund, asset value still $4,000.

But the quality of your investments does increase. You now have $1,000 generating tax-free income, rather than tax-deferred.

Dick

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.

Some time down the road, benefits and inheritence are means-tested. In state-1, the means (and resulting taxes) are higher than in state-2.

Victoria
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Post by jeffyscott » Mon Dec 07, 2009 9:51 pm

Wagnerjb wrote:Means testing for a Roth IRA means you get to pay taxes a second time (when you withdraw). I am not sure what means testing for a Traditional IRA means, but since you never paid tax on the assets I would think anything short of paying taxes twice would make the decision favor the Traditional IRA.



Current means testing provision is that if your income is above a certain level 50-85% of SS benefit is taxable. A Roth withdrawal does not count as income. If they changed the rules and did count it as income only for this purpose, with no income tax being due on the Roth withdrawal itself but having it possibly trigger income tax on SS, it would seem to either not have hurt to have converted or to still be a positive, as you would have to withdraw more from a TIRA than a Roth in order to have the same after tax income.
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Post by DickBenson » Mon Dec 07, 2009 10:50 pm

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).

Dick

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Post by VictoriaF » Tue Dec 08, 2009 1:43 pm

DickBenson wrote:
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).

Dick

Dick,

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 unpopular.
- 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.

Victoria
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Post by Beagler » Tue Dec 08, 2009 2:33 pm

The creativity of taxation should never be underestimated. Who would have thought that municipal bond income would ever be used as a means for testing Social Security benefits?

Then again, who would have ever thought that Social Security benefits would be subject to Federal taxation?
“The only place where success come before work is in the dictionary.” Abraham Lincoln. This post does not provide advice for specific individual situations and should not be construed as doing so.

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Post by Wagnerjb » Tue Dec 08, 2009 3:59 pm

jeffyscott wrote:
Wagnerjb wrote:Means testing for a Roth IRA means you get to pay taxes a second time (when you withdraw). I am not sure what means testing for a Traditional IRA means, but since you never paid tax on the assets I would think anything short of paying taxes twice would make the decision favor the Traditional IRA.



Current means testing provision is that if your income is above a certain level 50-85% of SS benefit is taxable. A Roth withdrawal does not count as income. If they changed the rules and did count it as income only for this purpose, with no income tax being due on the Roth withdrawal itself but having it possibly trigger income tax on SS, it would seem to either not have hurt to have converted or to still be a positive, as you would have to withdraw more from a TIRA than a Roth in order to have the same after tax income.


Fair enough Jeffy. I have to admit that I was concentrating on the $100,000+ a year earners, since those are the people who have a new decision to make in 2010. For those folks, they are probably going to exceed the SS taxation threshold either way, so that isn't a factor in their decision making.

I suppose if they had smaller TIRAs (and the rest in taxable), they might be looking at this threshold and figuring that converting to a Roth might keep them under the threshold. Right?

Best wishes.
Andy

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Post by ResNullius » Tue Dec 08, 2009 4:57 pm

The more folks write, the more I question whether it's smart to make the conversion, at least for those in upper income ranges. The government is going to get far more aggressive at reaching money held by the so-called wealthy, then slapping a new tax on it. This is a virtual certainty. Bottom line: Nothing is safe.

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