Everyone has been raving about the benefits of Roth IRA's-- but just how good are they for high income tax payers?
Hypothesis: which is better??
1. tax payer who earns $400K wants to setup a legacy for his grandkids. So his plan is to convert $100K from his traditional IRA into a Roth IRA, so that it will pass on to his grandkids tax-free. But since he is in the 35% tax bracket, he must pay $35,000 in income tax to do this conversion.
or,
2. would it be better to just invest $100,000 in a taxable investment account using a passive index fund that pays minimal dividend distributions and zero capital gain distributions. Then in 20 years the grandkids would get the assets in this brokerage account at the "stepped up" basis when he dies. Or if you cannot get the stepped up basis, at least it would be taxed as long term capital gains and not ordinary income like in a traditional IRA.
I am confused about which is better:
1. paying the income tax now at 35%, but zero when you take the money out of the Roth IRA.
2. making a pre-tax contribuion now, but taking the money out later at regular income tax rates of 35% using a traditional IRA ( I am assuming his tax bracket will be the same now as it will be then.)
3. using a taxable investment account and pay 35% tax on the initial investment, but only 15% capital gain tax on the accured profits when you take the money out.
It seems like the solution might change completely if Congress ever eliminates the capital gain tax, or reinstates the estate tax, or impliments a VAT tax like most of the rest of the developed world has.
It is really hard to plan for the future, when today's rules might not apply in the future.
Any thoughts???
Comments
The reality is that Washington will be sorely tempted in coming years to:
A) raise tax rates (for example, see http://www.marketwatch.com/story/higher-tax-rates-loom-for-401k-savers-2011-03-28 )
&
B) Eliminate the Roth as an option (for example, see http://articles.latimes.com/2011/apr/10/opinion/la-oe-scorse-roth-iras-20110410 )
I'd be inclined to use the Roth while it lasts
I like the Roth for young folk. In addition to the obvious tax advantage compounded over a longer time, if they're anything like I was when younger, those extra taxes at the time are likely $$ that would have been blown on non-essentials. However, since dollar cost averaging in, they don't have to worry about big downdrafts in markets the way you would after a big one-time conversion. The linked article mentions one way to mitigate that risk by converting into multiple Roths and than "recharacterizing" the ones that don't do well per tax code. Others on the board have used this strategy successfully.
We were fortunate to convert a portion back in early '09. Paid taxes out of pocket - not pulling from IRA. The upside to us, in addition to catching the market updraft, was we won't have to take mandatory withdrawals on that portion at age 70.5 as with traditional IRAs. The disadvantage was we aren't allowed to withdraw from the Roth for at least 5 years after conversion (unless paying 10% early withdrawal penalty). We've also dabbled in your third strategy, putting some in a non-IRA tax efficient fund just for variety. It's unclear to me how this would benefit you with a large sum, since you'd pay the (estimated) 35% on the $$ before you invest and than the current cap gains tax as well on withdrawal. Just a few random thoughts. FWIW
http://www.financial-planning.com/fp_issues/2012_2/betting-on-a-roth-conversion-2677059-1.html?zkPrintable=1&nopagination=1
If your aim is to "pass money on" (I'm available for adoption) you might think to look into gifting money over the course of years into accounts that the children would have in their names. I believe that gifting provides that the money gifted is taxed at the child's rate.
You might even combine this strategy with a 529 plan if your grand kids need help with educational related expenses. These dollars would be tax free to you as a roll over and tax free to them so long as they use the money accordingly.
Finally, a Roth conversion strategy might be still of use for remaining dollars. Here's an approach I try to employ.
http://www.mydollarplan.com/roth-conversion-strategy-minimize-tax/
I have also heard people paying life insurance premiums (from distributions in the traditional acct.) on a life insurance policy ($100k) that names the children as the beneficiaries. The death benefit would pass tax free to these beneficiaries. The taxes you pay on the premium payments would be smaller and spread out over your life time. But, then again, who wants to be thought of as the guy who is worth more to his grand kids...I won't go there.
Sitting down with a estate planner on a hourly basis might be money well spent.
Good luck