I wrote a response to a forum I infrequently visit about Roth conversion. The math types all were going through their analysis on why it doesn’t really make a difference bla bla bla, but they entirely missed the point of what money is about. You work hard, turn your human capital into value and stash some of that value into an account or two or three. That value doesn’t belong to you. It belongs to you AND the government. How that value is treated is a function of the account type in which you stash that value. If you put it in a post tax account it’s probable ongoing source of income for the government. You pay taxes on the ordinary income to start, stash what’s left and if it generates more value you are taxed again on the new value either as dividend or capital gain. If you loose the government doesn’t charge you for your pain and they give you a credit to charge against future profit. You can stash your value in a TIRA, an account that postpones your payment to the government, but make no mistake part of that value belongs to the government and it’s coming out at the most expensive tax rate, “ordinary income” Pound of flesh time. Ordinary income is progressive. The more you make the higher the “tax rate” not just the higher “the tax”. The effect is a “multiplier” not just a linear “adder” Double the income does not mean double the taxes it means 2.5x or 3x the taxes or more if you start adding surcharges and taxing cliffs. The third place you can stash your value is a Roth. With a Roth you square with the government once and then they leave you alone. You can withdraw without a progressive tax burden of either TIRA or post tax accounts. You can stash value in things like real estate or art or gold but similar tax burdens apply as post tax accounts.
The government has another trick. At age 70 BY LAW they start collecting their money from your TIRA on their schedule and you don’t have any say in it. The calendar rolls over and a predetermined increasing % of your TIRA must be extracted. The % extraction is progressive i.e. a multiplier. In addition as the distribution increases the tax increases as a multiplier because the tax code is progressive, so it’s multiplier times multiplier and you don’t have a thing to say about it. The government is nice and they don’t start this extraction till 70 so you’ll probably expire before your money expires but none the less the government is coming for their money at their leisure not yours. IRA like accounts are marketed such that you can stash value and avoid a high tax rate you may pay on the value immediately in order to subject yourself to the double multiplier effect later and the bet is your tax rate will be lower in your old age so the net result is you MAY pay less but then again you MAY not. It’s a bet! The control variable is the size of the amount of value in the TIRA.
The tax deferment is a middle class perk used to incentive retirement saving. As you make more the incentive disappears, in other words if you’re rich you get soaked today instead of in your old age. At some point the government realized this was a pretty good way to fleece the middle class so they set up a million “tax deferred” vehicles each with it’s peculiar tax treatment and extraction methodology and spending rules. Save for college? No problem 529b, can only be used to transfer wealth from you to something “accredited” Oh happy day if you’re a university. Jr gets drunk for 4 years on your nickel and Harvard’s tuition goes up at slightly above the rate of market return because that’s how much is in your 529b and they want the whole shooting match and you think what a fine deal. Your money grew for 20 years tax deferred just so Harvard could gobble it up, but you didn’t save enough and wound up with a student loan anyway and Jr graduates with a piece of paper and a hangover and a payment schedule, and you feel bad like somehow you failed. NEWS FLASH it was rigged against you. 529b’s are Harvard’s friend not your friend. The point being these tax deferred accounts are not necessarily your friends, yet how many times have your read “max out your tax deferred accounts it’s a no brainer”? You have to think through the liabilities and who benefits in the end.
Value is good for one thing: keeping you comfortable and alive, from your point of view. From the governments point of view your value is good for funding itself under penalty of law, and given the debt the sooner the better! So lets say you followed conventional wisdom and maxed out your retirement accounts. You did well and have a big wad in tax deferred money. You can max out something just shy of 80K/yr in tax deferred accounts. In 25 years you will own 3M+ of tax deferred money! At a 4% WR that’s $10K/mo baby plus SS to boot! Hubba Hubba! So you retire at 62 and take 80% of SS (say 25K) plus your $10K. Your accounts make 6%. 10K/mo is slightly above RMD on $3M. Your tax bill is $17,600 on your netted out TIRA + SS income of $141K/yr or 12.5 cents on the dollar You hit age 70 and the RMD for 8 years into retirement is 164K plus your SS net so your income is 185K and your tax $27,299 or 14.8 cents on the dollar. At age 75 your haul is 240K and your tax $40,419 or 17 cents on the dollar.
At 76 you get cancer and you beat it! But it takes 4 years at and extra $100K/yr expense. Your RMD at age 80 is 284K plus you had to take out an extra 100K so your tax that year on $384K is $78,500 or 20 cents on the dollar. Now your wife gets cancer and in 5 years she beats it at 100K/yr so at age 85 your pulling 482K out of the TIRA with a tax of $111,800 for 24 cents on the dollar.
Back when you were 65 you could have pealed off a million or two at a lower tax rate doing a Roth conversion. 250K/yr conversion (1M) would have cost you 17 cents on the dollar and then your done. Your TIRA would RMD at a far lower rate. 120K at age 70 with a 10 cents on the dollar tax at 75 $165K with 14 cents on the dollar at 80 $210K income with 15.7 cents on the dollar tax and at 85 $261K income at 17.4 cents tax You and your wife still get cancer and you still beat it but you pay the extra from the Roth tax free and enjoy lower taxes on your TIRA distribution as well.
That’s the real advantage of Roth conversion is you are prepaying for disaster coverage and tax free growth as opposed to tax deferred growth at a relatively low rate. In addition if you die your wife is left with paying single rates on her taxes so in her 86th year the 2M + 1M Roth payout would cost her on a 261 K RMD income 23 cents on the dollar On a 3M TIRA the RMD would be 397K and 28 cents on the dollar
So the calculation is colored by how the money is used and how rapidly it is needed. TIRA retirement is about doling out small aliquots of money and letting the “interest” pick up the slack. If bad things happen and you’re TIRA you are locked in with no flexibility. The government is coming for their money.