Roth Accounts: Seeing the Forest for the Trees

Kenigsberg, Matthew B.
September 2010
Journal of Financial Planning;Sep2010, Vol. 23 Issue 9, p52
Academic Journal
There are four distinct types of scenarios in which a decision can be required regarding the possible use of a Roth account: (1) Roth conversion tax cost funded through taxable assets, (2) equal contributions to Roth and traditional IRAs, (3) Roth conversion funded through qualified account proceeds, and (4) Roth contributions vs. grossed-up traditional contribution. This article provides an analysis framework for advisers to take several key factors into account and provide investors with a robust and consistent way of making decisions involving conversions and contributions to Roth accounts. Many think that Roth conversions and Roth contributions are a simple bet on one's future marginal income tax rate-that those who expect a higher rate when they draw down their assets should convert (or contribute) to Roth accounts, while those who expect a lower rate should not. In fact, future marginal income tax rates are only part of the story. Most investors consider qualified accounts to be assets. But a qualified account balance includes both assets and liabilities. The balance includes a deferred liability attributable to the income tax the investor would owe if he withdrew the entire account balance. The net value of the account is the account balance minus this deferred liability. Even if the eventual size of the deferred liability isn't known with certainty, it cannot be ignored. The deferred liability is essentially a debt, and Roth conversion (and by extension Roth contributions) may be seen as an opportunity to prepay it As with any debt, it may make sense to prepay this deferred liability depending on the interest rate, the maturity, the principal, and other factors.


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