Why Roth IRAs Get No Respect

At the beginning of 2010, an amazing investment opportunity opened to everyone. Yet many investors haven't yet budged toward taking advantage of it -- and a majority of them seem determined not to do it at all.

Mutual fund company Putnam Investments recently surveyed around 1,000 retirement savers to ask them if they planned to take advantage of a new rule allowing anyone to convert an existing retirement account to a Roth IRA. Despite the potential benefits of converting, over half said they had no plans to do so, citing uncertainty about whether the move would ultimately do them any good.

The Roth grand opening
Roth IRAs have been around since 1998, giving retirement savers a second weapon in their tax-favored account arsenal. Traditional IRAs and 401(k) plan accounts allow savers to deduct or exclude income from their current-year tax returns, giving them immediate savings and tax deferral throughout their careers. Once you retire, however, it's time to pay the piper -- whenever you take money out of your account, you'll have to include it as taxable income.

The emergence of the Roth gave investors another option. Instead of getting a tax break now, you could forego a deduction and instead get tax-free growth for the life of your account -- even when you take money out after you retire.

Roths, however, have been off-limits to high-income taxpayers. Until this year, if you earned too much, then you could neither contribute to a Roth nor convert an existing traditional IRA to a Roth. But this year, a portion of those restrictions were lifted. Now, anyone can convert to a Roth.

The sound of silence
But so far, response has been muted. T. Rowe Price told Bloomberg that it has seen only a "very small fraction" of its accounts convert. Fidelity saw conversions quadruple, but only to 58,000 -- likely not a huge number, given Fidelity's huge size overall.

So with the doors wide open, why aren't people converting? The key is that to convert, you have to commit to paying tax -- by including income either on this year's tax return or split evenly between your 2011 and 2012 returns. But there's all sorts of uncertainty about whether that's a smart move:

  • The conversion decision hinges on whether you believe your current tax rate is higher or lower than what you'll pay when you retire. But with tax laws up in the air, it's impossible to guess what your future tax rate may be.
  • Many are concerned that future tax laws may impose new retroactively applied taxes on Roths. They point to Social Security retirement benefits, which used to be tax-free but are now included in income for some taxpayers. Also, the government is using similar retroactive threats against Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) , with legislation that would force it and other companies to reserve against its derivative exposure the same way as top derivatives players JPMorgan Chase (NYSE: JPM  ) , Goldman Sachs (NYSE: GS  ) , and Bank of America (NYSE: BAC  ) -- even on contracts that they wrote years ago.
  • Similarly, changes in the structure of taxation could also render Roths moot. For instance, proposals for a value-added or consumption tax would force people to pay tax on what they spent, even if that money came from their Roths.

In fact, it's tempting for many to conclude that they're almost certain to earn less in retirement and therefore be in a lower tax bracket. But there are some flaws to that reasoning.

First, there are many moving pieces to your taxes after you retire. For instance, Roth withdrawals don't impact how much of your Social Security benefits get taxed, but regular IRA withdrawals do. That's something that doesn't appear in the tax rate tables, but it can cost you more come April.

There are also longer-term issues that play a role. You never have to take money out of your Roth IRA and can pass it untouched to your heirs if you like. They in turn can take it out in small pieces over the course of their lifetimes. Traditional IRAs, however, require you to take withdrawals after you turn 70 1/2, which reduces your ability to leave your retirement money to your heirs.

Take a closer look
Perhaps the biggest hesitation comes from the fact that stocks have rebounded so strongly. No one wants to convert and lock in tax on an amount that could disappear tomorrow. Even though the ability to recharacterize a Roth conversion later makes that less of a concern, it's a complicated provision that many probably don't understand.

It's true that converting doesn't make sense for everyone. But many who would potentially benefit are missing out. Unfortunately, it's all too likely that many will look back on their decisions not to convert as a lost opportunity.

Regardless of whether you have a Roth, you need to invest well. Fool retirement expert Robert Brokamp explains why stocks shall rise again.

Fool contributor Dan Caplinger respects his Roth. He and the Fool both own shares of Berkshire Hathaway, which is a Motley Fool Inside Value recommendation and a Motley Fool Stock Advisor selection. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy gets all the respect it deserves.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 29, 2010, at 12:00 PM, wessew wrote:

    The article is very correct in mentioning the political risk of converting, paying taxes up front and then having the rules of the game adversely changed. Are you willing to trust the politicians to not change the rules. There will have to go where the money is to close the budget gap. However, one of the hidden costs of converting is the loss of compounding of the prospective investment return on the funds that are used to pay the upfront taxes. Those returns are gone forever as is your cash to the IRS. The cost is significant and, over a ten year time period or longer, can be quite large due to the miracle of compounding return on return. In fact, breakeven analysis I have done in my own circumstance (with a number of reasonable assumptions) suggests that at age 60 I would need a time horizon of 25 years before breaking even under current law. And this assumes a prospective tax rate in retirement beyond 70-1/2 of 48%, well above current levels. I think it is a bad bet and that it is highly likely the law will be changed. Can you imagine the affront when the politicians realize the wealthy "fat cats" have permanently dodged any prospective increase in taxes on their retirement withdrawals. Not going to happen!

  • Report this Comment On April 29, 2010, at 5:40 PM, RobertC314 wrote:

    @wessew

    Good thoughts, but a little difficult to follow. It seems that you are claiming that compounding before taxes (i.e. in a 401k) leaves you with more money than compounding after taxes (i.e. Roth IRA). This is not true. If you are taxed at the same rate you come out even either way. A simple example illustrates: Assume $100 in earnings, a 25% tax rate, and 10% returns over 10 years:

    Traditional:

    Compound first: $100 * (1.10)^10 = $259.37

    Withdraw (and pay tax): $259.37 * (0.75) = $194.53

    Roth:

    Pay tax: $100 * (0.75) = $75.00

    Compount: $75 * (1.10)^10 = $194.53

    For the mathematically minded, you can see that it is simply a multiplication:

    Withdrawn_Amt = Initial_Amt * Return_Year1 * Return_Year2 * ... * (1 - Tax_Rate)

    Since multiplication is associative and commutative, it doesn't matter which one you do, Uncle Sam gets his dues and you end up with the same amount.

    The simplistic conclusion is (as mentioned in the article) if you expect to be paying higher taxes in retirement then a Roth is for you, if not then you should stick with traditional retirement accounts.

    One of the points of the article was that there are other factors that skew the balance slightly more in favor of Roth conversion such as whether taking a traditional distribution might put you over the threshold for paying taxes on your social security.

    There are also pluses for traditional products. For example, your book value is higher, so using a 401k to secure a loan (NOT recommended unless you can actually afford the loan without it) may get you a lower interest rate.

    -Robert

  • Report this Comment On April 29, 2010, at 5:53 PM, stan8331 wrote:

    Conversion is a fairly complicated issue with no simple, clear-cut solution. However, I think it makes great sense for most people to have a Roth as part of their investment portfolio, irrespective of the conversion issue. Possible future tax changes could go in many different directions - it's probably more likely that the basic tax rate would rise, versus any repeal of the Roth's tax exemption.

    No matter what happens, having a combination of both taxable and tax-exempt income available to us in retirement is probably the best hedge available. Even if there is a move to tax Roth income in some way, it's extremely unlikely to be taxed identically to income from currently taxable retirement accounts. Short of burying gold in the backyard, having both a Roth and a regular IRA or other tax-deferred retirement account is a great way to position oneself for whatever the future may hold.

  • Report this Comment On April 29, 2010, at 5:57 PM, Camacam wrote:

    Too many "ifs" to make definitive statements. However another consideration is the lowering of the estate tax thresholds. By using cash (which is now nearly worthless as an investment) to pay taxes now on conversions to a Roth you can lower your estate value. This can amount to a 55% savings on amounts over the threshold should Congress allow the Bush tax cuts to expire without modifications which seems more and more likely in the current climate.

  • Report this Comment On April 29, 2010, at 6:04 PM, FinnMcCoolIRA wrote:

    "wessew" IS ABSOLUTELY CORRECT IN HIGHLIGHTING THE POLITICAL RISK OF CONVERSION .... I PERSONALLY BELIEVE THAT THE POLITICAL RISK IS GREATER THAN ANY OF THE ECONOMIC PROBLEMS.

    THE ONLY HOPE IS TO INSURE THAT THOSE POLITICIANS NOW SUPPORTING "PROGRESSIVE" AGENDAS [E.G., 'CAP & TAX', HIGHER MARGINAL RATES, VAT, 'CARD CHECK', ETC.] BE SENT QUICKLY TO THE "UNEMPLOYMENT" LINE!

    "DANGER, DANGER WILL ROGERS"!!!

    WAKE UP - NOW.

  • Report this Comment On April 29, 2010, at 6:19 PM, Stocklovr wrote:

    From a tax perspective, you might want to read Ed Slott's book, "Stay Rich For Life". He is considered one of the foremost tax (NOT stock) authorities in the US. His opinion is to pay off the government and get them out of your life, i.e., convert!

    In his view, if the government does change the way they tax Roth accounts in the future, they normally grandfather in those who already have established accounts. Still... you can't predict and therefore plan what the government will do. One thing is for sure, we're not going remain at the 35% top tax rate. I believe that taxes, hidden as in VAT, etc., or income are going up.

    Slvr

  • Report this Comment On April 29, 2010, at 6:33 PM, Stocklovr wrote:

    Look at page 7 of the book I mentioned above. Income tax max rates were 7% in 1913 when they were established. (They were only mean't to punish the Vanderbilts, Morgans, etc., i.e., "the rich". How's that working out for ya today???) Here are few other periods from our glorious government:

    1936-1981 the lowest (top income rate) was 70% - the upper rate was 92%!!!

    1982-86 was ONLY 50%.

    If congress doesn't act (and it's doubtful they will), it's going up from 35% to 39.5%. While most of us may not be in the upper bracket, the lower brackets aren't far behind.

    I've already converted to a Roth. I'll take my chances with the law changes but I want the government out of my life wherever possible! If you think taxes will be lower in the future, good luck.

    -Slvr

  • Report this Comment On April 29, 2010, at 8:34 PM, cordwood wrote:

    My take is that the ever cash ravenous gov.mob is just trying to harvest revenue NOW...why else raise the limits re conversion? They dangle the carrot,knowing that they can just let it rot in your hands by changing the tax rules later....Soc. Security taxation was mentioned; that's a good example of leading us, [lulling us? ],into their temptation of tax free income in retirement.

  • Report this Comment On April 29, 2010, at 8:36 PM, mythshakr wrote:

    Of course it is entirely possible, albeit not probable, that in an attempt to save Social Security outflow payments Uncle may offer a break on the taxable IRA accounts to those that forego SS payments. Something such as for every dollar of SS benefit you forego in a year you can replace that dollar with an IRA dollar tax free.

  • Report this Comment On April 29, 2010, at 9:20 PM, Maple6239 wrote:

    If you do convert, convert into a number of Roths. Convert each different investment into a separate Roth. That way, you can recharacterize only your losing investments and keep all of the Roths that go up in value.

    I have checked rather extensively and can find no limit on the number of Roths that you can create. Ameritrade says that it will create as many as you want.

    Creating separate Roths establishes a win / can't lose situaton. I think that this is the best feature of the Roth opportunity, but no one ever mentions it.

    If I am incorrect, please post and let everyone know.

  • Report this Comment On April 29, 2010, at 9:24 PM, Maple6239 wrote:

    RobertC134 -

    Glad to see your post. You are absolutely correct.

    It is amazing to see how many writers do not understand the point.

  • Report this Comment On April 30, 2010, at 3:49 AM, Oppknocking wrote:

    Maple6239 - that is a great approach.

    I have been very surprised at how virtually ALL of the financial advisers I've heard or read have failed to recognize any particular value in the Roth, and how NONE have seen this particular value.

    In the recent run-up in the market I dedicated my Roth account to my highest conviction investments, so that my greatest gains would be un-taxed. That account is up over 300%, making the Roth VERY advantageous in terms of taxes. BUT - had I used Maple6239s approach, I would be in an even BETTER tax position.

  • Report this Comment On April 30, 2010, at 12:40 PM, EvilPhD wrote:

    I'm going to make my pitch that IRA's are the devil and to stay far FAR away from them.

    IRA's are based upon one major thing - you are going to die before the IRA matures.

    I saw what happened to the previous generation's 401K's and IRA's when the stock market when poop. That was a clear warning shot across the bow for me. Not only can it loose significant value, but you are forced to pay HUGE fines for getting out early. Taxes smashes, you are going to have to pay taxes on everything. It's the evil part of, oh you have a huge portion of my life's earnings and and you are going to rob double digits from that contractually because I want to put it somewhere else?

    Screw that.

    Put it in CD's that you can get out of in a relatively decent time frame. Stocks, bonds, ETF's. Anything. Everything else can be liquidated penalty free. That's more money in your pocket.

    Every other month I hear of another person I know kicking the bucket before 70. Ever think of where this money goes if you don't have a will? Or even what you could have done with that wealth if you had access to it besides trying to get something to eat and keep a roof over your head?

    The days of "Work in a company for 20 years to get a pension and matching 401K /IRA" are over. That model does not exist anymore.

    Pre-tax, post-tax doesn't matter.

    It's your money, use it how you want it.

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