Why are so many financial books, columnists, newletters so biased in favor of Roths?

[progree]

Last edited Fri Jan 1, 2021, 04:58 PM - Edit history (5)

First note that any Roth conversions for the 2020 tax year must be completed by December 31, 2020 (NOT April 15, 2021 as is the case of contributions). (Edit: obviously the deadline has passed, but never too soon to start considering a 2021 Roth conversion. And one can still contribute to a 2020 Roth until April 15, 2021).

I was struggling with a big Roth conversion decision a few days ago, and I decided just as a check on myself, to look at a spreadsheet that has been developed and touted by Bob Carlson, editor of the Retirement Watch newsletter, and author of The New Rules of Retirement and several other books.

https://www.retirementwatch.com/about-bob-carlson

Background Exposition (unfortunately)

My criticism of the three financial wizards' Roth analysis won't be understandable to most people, I don't think, without a bit of explanation first, unfortunately.

If you know this background material, feel free to skip it and go on to what this is all about: "Three Retirement Finance "Wizards" and their mistakes or apples vs. oranges assumptions". But it's important to understand the Side Account and its purpose, which may be different terminology than what you use.

Abbreviations:

TIRA - Traditional IRA.

RIRA and Roth IRA - Roth IRA

Side Account - a regular ordinary taxable account that plays various roles depending on whether we're talking about a Roth conversion or a choice between contributing to a TIRA or to a RIRA. Such as paying taxes on a Roth conversion. Or if we contribute to a TIRA, that's where the tax deduction savings goes. Also where Required Minimum Distributions go.

RMD - Required Minimum Distribution -- an amount one must withdraw from a TIRA and pay taxes on, beginning at age 72.

The starting point is that you have $10,000 in a Traditional IRA (TIRA) and $3,000 in a Side Account

The essence of the Roth conversion decision is that you have to analyze two options: the DO-NOTHING option (keep the TIRA and the Side Account the way they are), or the ROTH CONVERSION option:

DO-NOTHING OPTION: Keep the TIRA the way it is: Say you have $10,000 in a Traditional IRA (TIRA) and $3,000 in a regular taxable account, also known as a Side Account. If you decide NOT to make the Roth conversion, but just keep things status quo, then the TIRA will grow temporarily tax-free until you make required minimum distributions (RMDs) beginning at age 72, and you have to pay taxes on those at your ordinary tax rate at the time. If at some point you liquidate the TIRA account, the first step is transferring it to a regular taxable account and paying taxes on the entire amount liquidated.

(In Fidelity I just specify Withdraw from IRA, and specify the amount, and that is in effect what it does -- transfers the amount I withdraw to my regular taxable account, and then I get a 1099-R declaring that amount, which has to be declared on one's tax return and I have to pay taxes on it at my ordinary tax rate.)

In the meantime, the $3,000 Side Account grows, but one must pay taxes each year on any dividends and interest and capital gains distributions.

In the below I assume that the rate of return is such that the TIRA doubles in value after some N years (because it is growing temporarily tax free), while the Side Account, which is a regular taxable account, has the same rate-or-return pre-tax, but with taxes paid every year it only grows by a factor of 1.6 after-tax over the N years.

I don't show RMD's being taken, let's pretend we're in the pre- age 72 phase throughout the N years.

(If we did have to take some RMDs, I would show them removed from the TIRA and then being added to the Side Account. Additionally taxes would be paid on the RMD, which would come out of the side account. This would cut the growth of the Do-Nothing option by turning some of the tax-deferred growth to taxed annually growth).

Let's say after N years, for some reason we decide to withdraw the $20,000 from the TIRA, perhaps to pay a big bill of some kind or another. That's considered an IRA withdrawal, and taxes must be paid on that amount, at our ordinary tax rate which again is 30% in this example. I call it a "liquidation tax" because I'm wiping out the entire TIRA, but it's just a withdrawal of $20,000 to the IRS.



To be clear, the liquidation tax isn't paid on the entire $24,800 because $4,800 of that is the side account which isn't being liquidated, and anyway liquidation taxes aren't due even if that is taken and spent (leaving aside any capital gains taxes).

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ROTH CONVERSION OPTION: If instead, one decides to do a Roth conversion, and if the tax rate is 30% (including state income taxes), then to convert the $10,000 from the TIRA to a Roth IRA (RIRA), one tells Fidelity (or whoever) to transfer $10,000 in the TIRA account to the RIRA account. It then asks, "do you wish to do a Roth conversion?" and tells you the pros and cons of that, and especially that you will owe taxes if you do that.

Anyhoo, when done, $10,000 has been transferred from the TIRA to the RIRA, and one gets a 1099-R declaring that $10,000 has been converted, and that $10,000 has to be declared on one's tax return and taxes paid on it. At a 30% tax rate, that means $3,000 in taxes have to be paid. That money comes from the "Side Account". From then on forward the RIRA is tax-free forever. There are no required minimum distributions are required, and no taxes are ever paid on any withdrawals.

In short, one has taken $3,000 from the side account to pay the conversion taxes, leaving nothing in the side account.

Like in the TIRA, we assume that we need to liquidate the IRA, the RIRA in this scenario, for some reason, after N years.



Comparing the two, the Do Nothing option has a final value of $18,800 while the Roth conversion option has a final value of $20,000. Conclusion: go with the Roth conversion for a $1,200 higher net worth.

But what if we liquidated when, in our retirement, we were in a lower tax bracket, say 20%? Then the Do-Nothing would have a final value of $20,800, which is $800 more than the Roth option. Conclusion: do nothing and have a $800 higher net worth.

There are eligibility requirements and other details, which I'm not going into, here.

Three Retirement Finance "Wizards" and their mistakes or apples vs. oranges assumptions

My whole point in going thru the above is just to lay down the foundational basics. As necessary to explain the unfair assumptions and mistakes some financial "experts" make.

BOB CARLSON - In the Bob Carlson "nest-egg" scenario, he does include the side account thingy correctly (after all we have to account for the conversion taxes on the Roth IRA).

But in the Do-Nothing option, he simply throws RMDs away! Unfortunately I don't show RMDs in my example above, but they are a big deal if running this scenario out several years after age 72 (when RMDs are first required) and when they accumulate to a large sum (or are inherited, and the inheritees have to fully RMD-away the entire account within 10 years (SECURE Act). I don't know if this was an oversight or a deliberate decision, see Lynn, Union Tribune columnist below.

He also mistakenly pays a liquidation tax on the Side Account, the same as if it was a TIRA. Well, the Side Account is a regular taxable account, no taxes are owed even if it is taken and spent (exception: any capital gains taxes, and those would be at the lower capital gains tax rate rather than the ordinary tax rate he assumes). I'm sure this was just a mistake, but anyway, it also hurts the Do-Nothing Option.

Anyway, I'm pissed because I wasted many many hours before December 24th finding and confirming these shortcomings that made the spreadsheet worthless.

In his defense, he does look at many scenarios (including inheritance by the next generation), with many adjustable variables, but I think he lost sight of the forest for the trees.

Lynn, long-ago San Diego Union Tribune Financial Columnist and author of a couple retirement finance books (fortunately this one changed fields, so I'll leave out the full name)

This one is comparing contributing to a Traditional IRA vs contributing to a Roth (this is different than a Roth conversion), but anyway, if you contribute $10,000 to a TIRA, you get a $10,000 tax deduction which provides a $3,000 tax savings (again assuming a 30% tax rate) that in a fair comparison goes into a regular taxable account (Side Account) and is invested, with dividends and interests and cap gains distributions taxed annually like all regular accounts. Leaving one with $10,000 in a TIRA plus $3,000 in a Side Account at the beginning

Whereas if you contribute $10,000 to a Roth, there is no tax deduction, and so all you have is a Roth with $10,000 and a Side Account of $0.

But with breath-taking panache, he explicitly says people would just spend the tax deduction, so the Roth is ALWAYS a better choice. I agree, yup, if you throw away the TIRA contribution tax deduction and tax savings, then no way can a $10,000 TIRA compete with a $10,000 RIRA. Sigh. I had quite a correspondence with him.

Supposedly there are studies that show most people spend their RMDs. I'd like to look under the hood of those studies, I bet people with Roth's spend just as much money. Anyway, inarguably it's not an apples-to-apples comparison, and is not the basis for a valid comparison of the two options -- by assuming in option 1, one pisses away money, while in option 2, one is frugal.

I would also argue that some people who went with the Roth option spend some of their Roth, because after all, if you withdraw $1000 from your Roth, that's it, you pay no taxes and have $1,000 to spend.

Whereas someone with a TIRA who needed $1,000 would have to withdraw $1,429 from the TIRA and pay $429 taxes on it (30% tax rate assumption again). That wouldn't be very appealing at all to me.

Ed Slott, the famed IRA expert. If you haven't heard of him, you don't watch PBS or any other TV, shame shame.

Here I'm discussing his "Parlay Your IRA Into a Family Fortune", (c) 2005 book. I don't know if he's still presenting a phony comparison. To make a long story short, he completely ignores the Side Account, thus he ends up in effect comparing a $100,000 TIRA to a $100,000 RIRA. That's like throwing away the tax deduction when the TIRA was created. Or ignoring the conversion tax when a TIRA was converted to a Roth.

He does consider the RMDs, but he pays no taxes on the RMDs (that favors the TIRA), but assumes no growth in the RMDs either -- they just go under the mattress (that disfavors the TIRA). I've done some analysis that convince me that using reasonable rates of return and tax rates, that on net the two assumptions in in this paragraph disfavor the TIRA and thus relatively favors the Roth.

Frankly I think all three are upselling the Roth IRA to make it seem like they have a sure-fired sure-bet angle that others don't.

Those IRA conversion calculators on the web, and there are many (there are also many Contribute to a Traditional IRA vs. Contribute to a Roth IRA calculators)

These I've had better luck with, but my analysis of most were like nearly 20 years ago. I remember spending time with T Rowe Price's, which I didn't have any major issues with, but that was a long time ago. I also looked at MoneyChimps a few years ago and found it reasonable. I also developed my own based on MoneyChimp's and added some features, as an example of a few:

1. The option of the Side Account being invested in a buy-and-hold no-dividends equity fund with no dividends, so that no taxes are paid until the liquidation year when capital gains taxes are paid. This is the best option for the Side Account and makes the don't convert option look the best.

2. The option of the Side Account being invested in a no-dividend equity fund, but I sell it and buy another one every year, so in effect I pay capital gains taxes annually.

3. The option of the Side Account being invested in a bond fund (or a high dividend but no growth equity fund) where the interest (or dividends) are taxed every year.

My spreadsheet does all 3 of the scenarios (chosen to be extreme) and then I look at the results. With rate of returns on these and the core TIRA and on the Roth being variable, and having 3 time-period tax rates on each as well: a tax rate on the initial conversion, a tax rate during the pre-retirement accumulation phase, and a tax rate during the retirement phase.

My conclusion is that in any fair comparison, the Roth option always beats the no-convert do-nothing option if one assumes the same or higher tax rate in retirement than in one's conversion and accumulation years.

If one assumes lower tax rates in retirement years than the other years, however, then it becomes something that needs to be examined further with a good Roth conversion spreadsheet or calculator, of which I know of none that don't have some serious shortcomings.

It's also a scenario most people and financial planners assume (I think it is safe to say): tax rates in retirement (when there is little or no earned income) will be lower than in most of one's working years. Even when Social Security, a pension, and maybe an annuity kick in.

But be careful: putting all one's money in TIRA's and none in Roth's can lead to huge RMDs down the road (remember: TIRAs have RMD requirements, Roths don't), leading to surprisingly high taxable income and higher tax rates in retirement.

My decision

Fortunately it was easy -- the last 4 years, and 2020, and 2021 are special years for me where I can do Roth conversions at a 30% discount. Reason: if I do a $10,000 Roth conversion, my AGI goes up by $10,000, and what I can deduct in charitable contributions goes up by $3,000, so I end up only paying taxes on a $7,000 increase in taxable income. Making my tax rate on a Roth conversion effectively being 70% of what it normally would, and what it will be in later years, per my projections.

What's this about the magical charitable contribution deduction that makes Roth conversions cheaper?

I gave away my $500,000 farm to Population Connection back in 2016 in exchange for a charitable gift annuity CGA. I don't know how the calculations go, but per IRS regulations, PopConn figured (as I understand it) that the CGA is worth $360,000, so my net charitable contribution was really only $500,000 - 360,000 = $140,000. I am allowed to deduct that $140,000 on my taxes as a charitable contribution with TWO sucky-suck limits:

(a) I can deduct at most 30% of my AGI each year

(b) I have only 6 years to take these deductions: 2016, 2017, 2018, 2019, 2020, and 2021. If I can't deduct the entire $140,000 amount over these 6 years (and I can't), well, too bad, they say life sucks and then you die.

Anyway, it's provision (a) that affects my Roth conversion tax rate: each $1,000 increase in my Roth increases my AGI by $1,000 meaning I'm allowed another 30% of $1,000 = $300 charitable contribution deduction.

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If you've gotten this far, thanks for taking the time. The bottom line and the purpose of all this is to warn about really being careful which financial pundits to trust, even the ones with books and TV shows, and likewise be careful about any IRA conversion or contribution decision calculators or other decision-making tools you may find out there.

And to see what others do about decisions involving choices between traditional IRAs and Roth IRAs.



Edited to add: Full disclosure: I'm not a financial or tax professional. I've read a lot, consulted with tax and financial advisers a lot on these darn IRAs, studied conversion calculators and done a lot of analysis, and as an engineer I know math and spreadsheets, but at the end of the day I'm just another message board rando

[RandySF]

1. No taxes on the back end.

[progree]

3. True (as I mentioned), but there are taxes on the front end of a Roth conversion

That's money that is gone right at the beginning and so can't grow over the years.

Hopefully my examples, as simple and truncated as they are, showed that a difference in tax rates between the conversion year and the retirement years can swing the outcome.

[progree]

2. Some additional stuff (including cautionary stuff)

Last edited Mon Dec 28, 2020, 06:28 PM - Edit history (3)

To be clear, I like Roth conversions, I've been doing them almost every year since 1998 or 1999. But they aren't always the better choice than Traditional IRAs. And when you assume the same tax rate throughout, the Roth should come out somewhat better, but never way way better like a factor of 2 or something after 30 years.

My reason for dissecting Bob Carlson's spreadsheet was that he would often say in his newsletter that it takes several years before the Roth comes out better than the do-nothing option (sticking to the TIRA) at an 8% rate of return. That surprised me, so I wanted to see if I was missing something. I find if its better after many years, than its at least a little better just about right away. Anyway, after looking at his spreadsheet, I put zero regard on any conclusions he's reached.

Edited to add: Beware of the 5 year rule on Roth conversions and contributions

https://www.investopedia.com/ask/answers/05/waitingperiodroth.asp

In my words: if you withdraw from a Roth IRA within 5 years of creating it, or within 5 years of doing a Roth conversion to it, you may end up paying a 10% penalty plus taxes on the earnings (but not the original contribution or conversion amount). There's also something about withdrawing earnings before age 59 1/2 to read up on (I don't worry about it in my situation).

Edited to add: I do like Bob Carlson's Retirement Watch newsletter a lot, and I've been reading it for years. So it was a shock and disappointment to find such key errors in the spreadsheet, something that has been many years in development, albeit recently revised to comport with the SECURE Act (changing the first RMD age from 70.5 to 72, and ending the Stretch IRA -- in most cases inheritors have to liquidate their IRA account by the end of the 10th year). And realizing that not everyone is a skilled spreadsheet developer. As I mentioned it is a huge thing with many sheets, 3 major scenarios, and about a dozen or more user-changeable variables, so I have to give him credit for effort.

[sprinkleeninow]

4. Good God I read all of it but not word for word. You are a wizard.😍

If I may, I'll outline a condensed explanation of what I been going thru from last year. Getting multiple versions and answers as to how this thing'll work. I read extensively but the new IRS rules due to the pandemic make a difference in RMDs. An advisor says I didn't in 2020 but yes in 2021.

I just converted/rolled over 2 inherited 401ks into a traditional IRA. Some along the way advised it would be designated as an inherited IRA, but I think that's not correct. I'm 5 years older than my husband who reposed at age 66 in 2019. My understanding is that I need not take RMDs until 'he' would've reached the age requirement of 71 or 72. So I'm not pressured to start in 2021? Naturally I don't want to get into trouble and end up paying penalties.

The investment firm I did this with asked if I wanted to consider a Roth and I said no. Only bc of my age.

[progree]

5. IRAHELP.COM

Discussion boards: https://www.irahelp.com/phpBB

I got a lot of help there when my sister and I inherited IRA accounts from our parents. These are real experts in most cases answering questions, at least back then in the mid 2000's. Haven't visited there in a long time.

I'm 99.9% sure you don't have to worry about RMDs on any kind of IRA, inherited or regular or otherwise, in 2020.

I would think an inherited 401k would have to be rolled over into an inherited IRA. That's just a guess on my part, but seems logical to me.

If it's an inherited IRA, known as a beneficiary distribution account IRA, then you must take RMD distributions every year, no matter what your age (exception: 2020). I've been taking RMDs on my inherited IRAs since I was in my mid-50's. (My sister and I have been over this with many tax and financial advisers). But my parents were over 80 when they passed. It might be different if they had passed before age 70.5 ... maybe I wouldn't have had to begin taking RMDs on it right away in that case, dunno.

I think Roth conversions are a good idea at any age if you expect your tax rate in the future to be the same or higher than it is now. Just don't do a too-big Roth conversion in one year, because the conversion amount is all taxable income, and a big conversion might push you into a higher tax bracket. I'd tell the investment firm, "maybe" if it was me

Edited to add: Full disclosure: I'm not a financial or tax professional. I've read a lot, consulted with tax and financial advisers a lot on these darn IRAs, studied conversion calculators and done a lot of analysis, and as an engineer I know math and spreadsheets, but at the end of the day I'm just another message board rando

[Pobeka]

6. It will (of course) depend on the particular case.

Being a programmer, I made a simple program that put in our basic spending needs (with different inflation factors for categories like health insurance, etc).

I coded in the federal tax regulations, medicare, etc.

The tricky part is comparing a ROTH vs a TIRA is you don't own all the $ in the TIRA. What I did was see what the tax rate was going to be with SS and RMD's and then discount the TIRA by that amount at the final step to compare it to the ROTH

Then I ran scenarios with different assumed rates of growth (2% thru 8%) on investments.

For our case, in general, the case where we convert 50% of our asset to ROTH, the ROTH scenario starts to win about 10 years out. Since we don't need that money in that time frame it makes sense to have those dollars in an account with no worries about taxes in the future, and to protect the TIRA from getting so large it may get taxed at a higher bracket in the future.

[trof]

7. You must know that NOBODY will read a post this long?

Bottom line: If we're talking serious bucks (hundreds of thousands of dollars) the conversion penalty is way high.

[progree]

8. So is paying taxes on the back end when you withdraw. But anyway, people with large TIRA's

Last edited Tue Jan 12, 2021, 12:30 PM - Edit history (1)

should probably convert -- if it makes sense to convert -- relatively small amounts annually. I've been doing conversions since 1999, a little at a time, though I skipped maybe 3 years. Generally to convert enough to still stay in the same tax bracket, and maybe a little bit in the next tax bracket. In most of these years, that meant converting until I topped off the 15% bracket and even went some way into the 25% bracket.

The plan was on the withdrawal end, when I had used up all my non-retirement savings, I would withdraw from the traditional IRA (TIRA) first. As needed I would withdraw from the TIRA up to the top of the 15% bracket. Then, if more is needed, I would withdraw from Roth after that in a given year, thus avoiding 25% and higher taxes, e.g. because of major medical expenses.

My situation would have been a tax disaster if I had not converted any of it. My Traditional IRA RMDs after about 10 years would have driven me way into the next bracket at least.

As for nobody reading a post this long, I don't know about NOBODY. Absolutes (like ALL, NONE, NOBODY, EVERY, NEVER etc.) are rarely true. But I understood probably only someone who was actually seriously considering a conversion in what little time remained in 2020 (I posted early A.M. Dec 28) would likely read it all. Most who are interested in the topic would skim, skip and read what might be important to them - hopefully the part about how people who claim to be IRA experts (and generally regarded as such) making so many dodgy assumptions to make Roths look like an almost always sure bet. And likely one's financial adviser gloms off their work and doesn't dig deep into it, or have the analytical skills to do such a deep dive.

I spent the better part of 3 days analyzing the decision and going through the Bob Carlson spreadsheet. But then some of us are more serious about our investments than others.

In the past, I've been a part of very long discussions in other forums where we really went into the math and analysis. But I realize that's not everyone's cup of tea. I find it a more fruitful and interesting use of my time, than for example, clipping and sorting grocery coupons, and then buying that unhealthy crap.

Edited to add: it was also meant to hopefully trigger a discussion about the subject. I'm meaning to get back to Pobeka #6, but it's been a busy time.

1/11 11:11pm - Edited for clarity -- particularly the title and first sentence to say that if you do have a large amount to convert, and if it makes sense to convert, it's probably best to do it in relatively small amounts over several years.