Bryan Caplan  

Roth Conversion Bleg

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Greg Mankiw's rarely-offered financial advice has put me in a mild panic:
[I]n light of the fiscal situation we are facing, I will pass along one tidbit.  Consider converting some of your retirement savings into a Roth IRA. Over the past few years, I have converted all that I can, which is about half of my retirement savings.
The last time I investigated this, I couldn't take advantage of the Roth conversion because only 401k, 403b, and 457 plans from previous employers were eligible.  Since GMU econ has been my only real job, I seemed to be out of luck.  However, the law changed in 2010, and reading the most recent google hits, I still can't quite figure out if people in my situation remain ineligible.

Mankiw's ability to take advantage of the Roth conversion amplifies my doubt.  Unless he quit Harvard to work at the CEA, hasn't Mankiw been with the same employer even longer than me?

If you know the definitive answer, please share it, with references.


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COMMENTS (22 to date)
OneEyedMan writes:

I think you are still intelligible. However, many employers allow you to have a Roth style 401k, 403b, or 457 instead of a traditional one. If that's so for GMU, even if you can't switch you could make all future contributions after tax.

Jim Ancona writes:

This advice assumes that the after-tax Roth contributions will remain untaxed on withdrawal in the future. Is that a good assumption? Or might Congress have other ideas in the future?

Megan McArdle discussed this a while back: http://www.theatlantic.com/business/archive/2011/04/how-safe-is-your-roth-ira/237081/

Peter H writes:

Reading this:

http://www.irs.gov/pub/irs-drop/notice_2009-75.pdf

It seems like there's some good info starting at the bottom of page 3 into page 4. I'm not an expert on this though, so no definitive answer. It looks like you can do what you're wanting to do, but talk to your accountant.

" A conversion may be accomplished by
means of a rollover, trustee-to- trustee transfer, or account redesignation.
Regardless of the means used to convert, any amount converted from a nonRoth IRA to a Roth IRA is treated as distributed from the non-Roth IRA and rolled
over to the Roth IRA. "

David R. Henderson writes:

@Bryan,
I got in that same panic for a short time. Then I realized that Greg is assuming that the rules for Roth IRAs won't change. Specifically, he's assuming that the government will never tax them. I don't have that same confidence. So you could end up paying a boatload of taxes now when you convert and then further taxes down the road when you pull them out. FWIW, I'm sticking.

Brent writes:

Moreover, if there is a lot of inflation, you could very well be better off "buying more" in the present (avoiding the present taxes) and paying taxes on the larger, inflated returns later. Plus, you don't know what the tax rates will be in the future. It is possible that sanity will return one day and tax rates will be lower.

Charlie writes:

If you have a year with lower income than now because you leave your job or retire, that would be a better time to convert. Deductible IRA/401(k) contributions come "off the top" of your income now. In periods of low income or retirement, they "fill up the bottom" and you can convert at much lower tax rates. Much of this account may not be taxed at all, or be taxed at federal rates of 10%, 15%, etc (unless you will have a pension). The progressive tax system isn't likely to go away.

Ask the forum on bogleheads.org for more specific advice on your situation.

Silas Barta writes:

In other words, people are finally realizing that the taxes to worry about are the ones that will happen way down the line when our fiscal situation is even worse and harder to put off?

Fine, but is the government then really just going to shrug its collective shoulders and say, "gosh, that money's in Roth-instruments, guess it's off the table for taxation!" No, they'll start reneging on its promises of tax treatment.

8 writes:

A future Congress can decide to tax your withdrawals. What are the odds of that happening?

Joe In Morgantown writes:

Even if the Roth rules don't change, a switch to a VAT tax is possible.

liberty writes:

What strikes me is how complicated the rules must be that an economics professor could be left unsure whether he is eligible, in addition to whether it is worthwhile to switch if he is, despite having such a simple work history... Are we better off for having these choices?

Eric writes:

I want to second the statements of many commenters above. I'm much more worried that the government will change the tax rules on Roth withdrawals than I am about near-term tax rules. It never occurs to me to even consider switching anymore.

jb writes:

Yeah, it's a gamble - do you bet that taxes on 401K/IRA/tax-deferred accounts are going to substantially rise in the future? Or do you bet that Roth IRAs will get a "one time tax" sometime in the future, and will that "one time tax" swamp any benefit you might have gotten from switching.

Argument for Roth IRA "one time tax" - the humans who run our government will break all sorts of promises in order to fund their pet projects, _especially_ promises that were made by others, in the past.

Argument against it: Most people with Roth IRAs will be very, very upset, and complain loudly about the broken promise.


Argument for: Those people who complain will be called greedy rich people, and it will be implied that they're not paying their "fair share". It will be "common knowledge" that Roth IRAs were created by rich folks to protect their money so it couldn't be used to fund social programs, thus perpetuating the inequality of our society.


The good news - you can't avoid this bet - you're making the bet whether you want to or not. So go with your gut. My gut says that all my savings will be destroyed by future high inflation, and I'll be eating cat food and living in a box, so it doesn't matter whether the box has '401k' on the side, or 'Roth IRA'. It will still fail to keep out the rats.

Charlie writes:

"Mankiw's ability to take advantage of the Roth conversion amplifies my doubt. Unless he quit Harvard to work at the CEA, hasn't Mankiw been with the same employer even longer than me?"

Mankiw linked to an article from Vanguard about converting a Traditional IRA to a Roth IRA. I am not a tax planning expert, but I believe you can convert an IRA at any time. This is generally not true of 401(k) plans, and depends on the specific rules governing your plan. Sometimes you can roll over part of 401(k) directly to an IRA. Sometimes you may be able to do an in-service conversion. I think it's plan specific.

A few good blog and wiki entires to read over.
http://thefinancebuff.com/case-against-roth-401k.html
http://thefinancebuff.com/in-service-withdrawal-the-law-and-the-plan-rules.html
http://thefinancebuff.com/in-plan-roth-rollover-practically-useless.html
http://www.bogleheads.org/wiki/Roth_IRA_conversion

Personally, I think everyone is being ridiculous with the Roth IRA taxation hysteria. Everything in a Roth IRA has already been taxed as income. A Roth IRA is functionally equivalent to a Traditional IRA except for the exact time you are taxed. Any scenario where Roth IRAs have a new tax added on to them that sees Traditional IRAs escape higher taxes seems unlikely.

But if you're really that worried about it, use a Traditional IRA or 401(k). It's probably better for the vast majority of investors anyway.

kashof writes:

Bryan-

Mistake number one is to try to plan your own finances based on what you think someone else's are. You will lose everytime.

@Charlie is right. If you are ever going to do a conversion wait for a year when you are at a lower marginal rate, ie if you quit/lose your job, you have significant deductions due to a life circumstance, or even when you retire. If you are super sophisticated, you can even do a partial conversion in order to keep the money you do convert taxed at no more than your current marginal rate.

A Roth does have several advantages over the Traditional IRA including not ever having to take distributions and withdrawing contributions tax free after the account is opened for 5 years.

While taxing Roth distributions might occur, I suspect forced purchases of US gov't debt in the name of safe and secure retirement might be a more likely and politically doable step.

Basic financial advice. If you are panicking over how your finances are structured, it's time to hire an advisor. You have my e-mail, and as of last Friday, you and I are one degree of separation:)

Slocum writes:

Roth conversions of 401Ks always struck me as dumb. Even if overall tax rates are going up, your *personal* tax rate is probably going to go down quite a lot after you retire. And keep in mind that any income you convert from a 401K to a Roth will be taxed at your highest marginal rate. And also, after retirement, you'll have a lot of flexibility in deciding which years to make 401K withdrawals to minimize your tax obligations.

Charlie O writes:

These two articles are about 401k, but I assume the rules are the same for 403b. You can convert current 401k to roth only if your employer offers roth as an investment option in your 401k.

http://www.foxbusiness.com/personal-finance/2011/04/01/411-roth-401k-conversions/

http://www.cbsnews.com/8301-505146_162-39942184/roth-401k-conversion-pros-and-cons/

John Thacker writes:

It's also possible to hedge against future tax treatment by doing a partial conversion, if you're unsure.

Personally, I think everyone is being ridiculous with the Roth IRA taxation hysteria. Everything in a Roth IRA has already been taxed as income.

I hear this, and I think of people telling local and state government employees all over the country not to worry about their pensions. Yes, it's "already been taxed as income," but it's been allowed to grow based on investment returns and capital tax free. My other investments were "already taxed as income." I don't find that the double taxation argument has been particularly effective in eliminating capital gains taxes, etc., so I think that taxes on the gains-- in essence converting them to a non-deductible traditional IRA-- are indeed possible, perhaps at a lower rate.

When all the promises made can't be kept, some will be broken.

Matt C writes:

+1 to the point that a VAT screws Roth savers and doesn't even require any broken promises.

You are making a deal with the devil in any IRA plan. You like guesses, I am guessing that some kind of nastiness for IRA savers in the next 20 years is at least 80% likely. They're already floating ideas around.

I still fund my IRAs (mostly trad, a little Roth) but I don't max them out any more. Plowing all your savings into IRA type accounts is a bad idea IMO.

TMS writes:

As Charlie mentions above, it really depends on your plan. You generally have to get the money out of the 401K plan and into a Trad IRA, and many plans don't allow in-service distributions.

If all of your retirement assets are in a 401K type plan but your income is too high for a Roth contribution, then you can contribute to a Roth using a backdoor method. Make a non-deductible contribution to a Trad IRA and then immediately convert to a Roth. If you have Trad IRA assets, then this strategy won't work as well.

A Roth IRA is functionally equivalent to a Traditional IRA except for the exact time you are taxed. "

That is true, but a Roth IRA > Trad IRA + Taxable Account. For example, assuming 25% tax rate now and in the future, $100K in a Roth is better than $100K in a Trad IRA and $25K in a Taxable Investment account.


Charlie writes:
For example, assuming 25% tax rate now and in the future, $100K in a Roth is better than $100K in a Trad IRA and $25K in a Taxable Investment account.

This is only true if you're maxing tax-advantaged accounts. If you're not maxing out these accounts, you would want to make a comparison like investing $10k in a Roth account vs investing $13.3k in a Traditional account (assuming a 25% tax rate at both ends). Note that this 25% tax rate assumption is not necessarily accurate for the reasons I linked to earlier.

For someone maxing accounts, the Roth does win if the tax rates are equal. There is a more detailed analysis here along with a useful calculator. Play with the numbers to compare different scenarios.
http://thefinancebuff.com/roth-401k-for-people-who-contribute-max.html

Daniel Lauffer writes:

You could do the conversion in an IRA. In an employer sponsored plan, (if they allow a Roth conversion) it is usually limited only to sources of money that can also be withdrawn. This usually includes money that was previously rolled over from another plan or after-tax contributions. Some companies let you withdraw from other sources as well but those are rare.

Jim writes:

Its likely that Greg has had other income that was diverted into an IRA or SEP through the years if its true that he has had no other major employers from which to transfer a 401k or other ERISA plan to a rollover IRA.

I'm certain that Greg has had other income sources over the years from books, consulting, etc.

...and I use to be a tax expert in this area but now I only study truly predictable things like astrology and tarot.

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