The dirty little secret about IRAs

When using the term IRA, I am actually including all tax advantaged retirement plans such as Simple IRAs, 401Ks, Keoghs, SEPS and various other plans for government and non profits.  The common denominator to all of these plans is that they are essentially an IRA of one form or another and are almost always a Traditional IRA.  Therefore, if you participate in any of these plans, you must understand the secret of them.

We all know that traditional IRAs are a tax advantaged savings plan which allows you to invest before tax dollars and to have those dollars appreciate without tax in the retirement account.  Compounding is accelerated because no taxes are paid as the account appreciates each year.  The dirty little secret is that taxes are only deferred; they are not avoided.  Furthermore, they are deferred to ordinary income at the time of redemption whereas they might have been taxed as dividend income and/or capital gains if invested outside of the IRA. One might even say that for the privilege of deferring tax on the income placed in an IRA, the IRS converts low tax rate dividends and capital gains into higher tax rate ordinary income to be paid at a future date, and the future tax rate. This guarantees that you pay the highest possible tax on all gains realized throughout the life of the investment. And finally, at age 70 ½, you must take a Minimum Required Distribution, MRD, (and pay income taxes at your highest incremental rate) for the rest of your life, even if you do not need or do not want the additional income. You are denied the option of saving for your heirs thus complicating estate planning.

So why do we do traditional IRAs?  When you are just starting out in your retirement investing, it may be a real advantage to invest before tax income dollars as that is more affordable. The theory behind the tax-deferred IRA is that you will be in a lower tax bracket in retirement and thus pay fewer taxes in retirement than you would at the time of investment.  There are three problems with this theory:

1. Often your retirement income after deductions is not much less than your working income; at least that is the goal I set for my clients. Also, the income bracket you are in when you are in your 20s and 30s is almost always lower than the bracket you are in as you approach retirement. Therefore, when you withdraw funds, for you may be in the same or higher tax bracket (most certainly at higher real tax rates) than when you invested and have no real saving.

2. All gains achieved throughout the term of the investment will be taxed at the ordinary income tax rate at the time of withdrawal.

3. Taxes today are at an historic low; and I am certain that taxes will be higher in the future.

   Therefore, you will defer taxes at a very low rate today until retirement when you will pay taxes at a higher rate.  That is not what we intend to do.

Why is this such an important topic now?  For years you have been allowed to convert traditional IRA to Roth IRAs but there has been a relatively low income cap that prohibited most of us from making the conversion.  In 2010, that cap is removed and everyone at any income level is permitted to make the conversion.  If you are ten years or more away from planning to withdraw funds, or being forced to make an MRD, the most important financial move you can make this year is to convert traditional IRAs to Roth IRAs.  You will need to pay income tax on the funds you convert, but you will pay them at the 2010 and/or 2011 rate which I am confident will be the lowest rates you will see in your lifetime.  You must pay those taxes from sources outside of the IRA, not by law but for maximum leverage, resulting in a new Roth IRA of the exact value of the old traditional IRA.  The difference is the Roth will now be tax free forever with the following benefits:

1. Principle, interest, dividends and capital gains are tax free for you and your heirs.

2. Gains on the Roth are tax-exempt, not tax-deferred.

3. Taxes were paid at lowest rate you will ever see.

4. No MRD required ever; you can leave 100% to your heirs’ tax free.

5. If needed, you can withdraw part of, or all of the principal at any age without penalty (10% penalty for any withdrawal from traditional IRAs if under 59 ½).

6. Tax due at conversion can be spread over two years; but I strongly recommend against that due to imminent tax increases. (The 2011 tax rate may well be higher.)

    

When converting a large IRA, there are tax considerations to be made to avoid creeping into the highest tax brackets and you should discuss these strategies with your CPA or tax consultant.  There are many Roth conversion calculators available on the internet; try them out.  Use a calculator that allows you to input future tax rates and be realistic in assuming much higher rates in the future.  I guarantee that all of them will show a major benefit if you are ten or more years from needing the funds or being forced into an MRD, even at constant tax rates.  

Remember to grow and preserve wealth, we do not want to defer low taxes today to higher taxes in the future.  We do not want to pay future income tax rates on dividends and capital gains; we prefer tax-exempt to tax-deferred.  And finally, if we are successful in creating and growing wealth, we would like the option of passing that on to our children and grandchildren.

Give it some thought.

Larry Hollatz, RFC®