Understanding Roth Conversions
By Terry Coxon, Casey Research
It’s evident that, unless your situation is particularly unique, converting your traditional IRA to a Roth IRA is a wise decision. This isn’t merely a small gain—it’s substantial. Delaying this conversion could result in paying significantly more in taxes down the line, effectively throwing money away. None of us want that outcome.
Your IRA is a dynamic entity, constantly receiving and dispensing funds while your investments shift over time. Its impact is felt across the years, making the decision of whether to convert more complex than merely swapping out one stock for another. However, there’s a straightforward way to approach this dilemma.
Comparative Analysis
With a traditional IRA, you are permitted to contribute $5,000 annually from your income (or $6,000 if you’re aged 51 or older). Additionally, provided your income is within limits, you can deduct this contribution from your taxable income. While the earnings within the IRA grow tax-deferred, any withdrawals are taxed as income, except for non-deductible contributions, which are tax-free upon withdrawal.
Conversely, a Roth IRA allows you to contribute the same amounts, but you cannot deduct these contributions from your taxable income. Nonetheless, like the traditional IRA, the earnings within a Roth grow tax-free. When you withdraw funds, assuming you’ve met certain age and duration criteria, you receive the money tax-free.
Both traditional and Roth IRAs derive their wealth-building power from tax-deferred compounding. To illustrate this, let’s compare a traditional IRA with a standard, taxable savings account:
– An individual decides to forgo $1,000 in spending.
– He plans to save it for 30 years.
– His effective tax rate remains constant at 40% throughout this period.
– The before-tax return averages 5% per annum.
In an ordinary savings account, the $1,000 earns after-tax interest at a rate of 3%, resulting in $2,427 at the end of 30 years. For a traditional IRA, however, the initial amount effectively invested is $1,666.67, yielding $7,203 after 30 years. After taxes, the investor is left with $4,322—an impressive 78% increase compared to the savings account.
How does a Roth IRA compare? It starts with the same $1,000 and grows tax-free to $4,322 after 30 years, all of which is spendable cash upon withdrawal.
Lastly, consider a “Lame IRA”—a traditional IRA funded with non-deductible contributions due to high income. This may also grow to $4,322 after 30 years, but only $2,992 remains after tax, making it the least favorable option, albeit still superior to a standard savings account.
Maximizing Your IRA
A 78% increase from a traditional IRA is a significant incentive for completing a few forms. To uncover how much of your assets should transition to a traditional IRA, the answer is straightforward: any interest-generating dollar assets (e.g., cash, money market funds) in your portfolio should go into the IRA, as they will grow tax-deferred.
The same principle applies to any segment of your portfolio designated for short-term trades. Short-term capital gains are treated as ordinary income unless realized within an IRA; therefore, it’s prudent to keep these in tax-advantaged accounts.
For longer-term investments, if your traditional IRA has less than 20 years to grow, it is better not to transfer stocks intended for longer holding periods, as this could convert lower-tax long-term gains into higher-tax ordinary income.
Regarding gold investments, the top federal tax rate on profits from gold is around 28%, which is generally lower than ordinary income tax rates for traditional IRAs. If you plan on liquidating your IRA soon, it’s not the optimal place for gold. However, if your IRA has longevity, it’s wise to include gold, provided your IRA can accommodate the broader asset types.
Typically, it’s advantageous to move directly owned assets into a traditional IRA, but avoid transferring low-tax assets that may incur higher tax rates once moved.
When it comes to Roth IRAs, the picture looks clearer. Ideally, it would be beneficial to have all your investments inside a Roth IRA, maximizing tax-free growth on both earnings and distributions. While this option isn’t fully available, it underscores that, generally, a larger Roth IRA is unequivocally advantageous. This leads to the rationale behind Roth conversions.
Understanding the Implications of a Traditional IRA
Let’s assume once more that you maintain a steady tax rate of 40%. Regardless of the IRA’s performance, you’ll incur a 40% tax on every dollar withdrawn, essentially retaining only 60 cents. This structure effectively turns your traditional IRA into what resembles a partnership with the government, where 60% belongs to you, and 40% remains the government’s share.
When you evaluate your 60% share, you’ll see its gains are tax-free during growth, and withdrawals are also tax-free. This makes your traditional IRA a virtual Roth IRA. So, if the government were to offer to sell its share of the partnership, would you take it? The conversion from a traditional IRA to a Roth is precisely that offer—a transition to a zero-tax environment. Given current tax trends, it’s wise to move your assets accordingly.
Additional Benefits of Conversion
Transitioning more of your financial resources to a tax-free Roth environment makes conversion attractive, but several other advantages support this decision:
- Inflation Protection: During inflationary periods, the tax benefits of IRA protection become even more significant. Gains classified as income can be misleading when accounting for inflation, but keeping assets in an IRA shields you from these taxes.
- No Mandatory Distributions: Traditional IRAs require minimum distributions starting at age 70.5, effectively ushering your wealth back into a fully taxed domain. Roth IRAs, however, entail no such requirements, allowing your assets to continue growing.
- Convert Non-Deductible Contributions: If any traditional IRA contributions were non-deductible, moving these to a Roth incurs no tax costs and allows future earnings to accumulate tax-free.
- Broad Range of Investments: Roth IRAs can encompass various investment types. By transitioning your IRA to a custodian who allows broader investment strategies, you gain more freedom in managing your assets.
Conclusion
The advantages of converting a traditional IRA to a Roth are compelling. You can push more wealth into a tax-free domain, enhance your resilience to inflation, avoid stringent withdrawal rules, and leverage non-deductible contributions for growth. The benefits are strong enough that if your traditional IRA could respond, it would likely be proclaiming, “Convert me! Convert me!” By taking action on this opportunity, you not only secure your financial future but also diminish the government’s capacity for excess spending.
Sincerely,
Terry Coxon
for Economic Prism
[Editor’s Note: In addition to his role as economist and editor with Casey Research, Terry Coxon is a principal in Passport IRA and the author of Unleash your IRA. The information provided should not be construed as legal or tax advice. It’s advisable to consult your CPA or tax advisor before considering a Roth conversion. Additionally, navigate the complex landscape of exchange-traded funds (ETFs) with caution; this report on the top ten misleading ETFs can aid in avoiding pitfalls.]