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Roth Conversion Analysis: Not Breakeven Analysis

A reader writes in, asking:

“I am planning to do a smallish conversion each year before I turn 72. I am 66.

Now though, I recall hearing a CFP say that it is important also to do a ‘breakeven analysis’ before converting money from a traditional to a Roth IRA. He has found that, for most of his clients, the breakeven point is too distant for a conversion to provide a meaningful benefit. Clients would have to be in their 90s.

If you have room in your blog, please touch on what a “breakeven analysis” is in the context of a Roth conversion and how to do it.”

This is a common misconception — one that is common even among financial professionals, unfortunately.

In most cases, breakeven analysis simply is not applicable to a Roth conversion decision. (There is one specific exception, discussed below.) For a Roth conversion decision, the length of time in question usually does not matter at all.

The reason has to do with the commutative property of multiplication. That’s the rule from grade school math that tells us that A x B x C is the same as C x B x A. The order in which we multiply figures is irrelevant — we get the same answer every time.

When you pay taxes on a distribution from a tax-deferred account, it’s a multiplication function. For example, if you take a distribution and you have a 20% total marginal tax rate, you’d be multiplying the amount by 0.8 in order to see how much is left after taxes. And the same is true for a Roth conversion, if you pay the tax from the IRA.

Imagine that you are considering doing a $50,000 conversion. And imagine that you have a 20% tax rate right now. If you convert it, you’re left with $40,000 in a Roth IRA. And the Roth IRA can now grow tax-free, which means your after-tax value can be represented as:

  • $50,000 x 0.8 x Year-1 return x Year-2 return x [any additional years of returns]

(Note that in the above, a 7% return would mean multiplying by 1.07. A negative 5% return would mean multiplying by 0.95.)

Or, you can keep the money in a traditional IRA, let it grow, and pay tax later. If we assume that you would also have a 20% tax rate later, then your after-tax value can be represented as:

  • $50,000 x Year-1 return x Year-2 return x [any additional years of returns] x 0.8

And the key point here is that those are the same thing. It doesn’t matter whether the returns are good or bad. Nor does it matter how many years of returns there are in between. It’s a textbook case of the commutative property of multiplication.

Breakeven analysis is predicated on the concept that you’re paying some cost up front, which is bad, and that you have to wait for some period of time before paying that cost is “worth it.” But with Roth conversion analysis, if you don’t pay the cost now, you have to pay it later (i.e., the cost cannot be completely avoided). And because the figures in question are all multiplication, it’s no worse to pay it sooner rather than later. (And in fact paying it sooner is often advantageous, because waiting until later to pay the tax often means the distributions themselves are larger — because the account has grown — which can itself increase the rate of tax. And again, the rate of tax is what we care about.)

Some smarty-pants might say, “but you’re forgetting time value of money! Time value of money tells us that it’s better to pay the cost later.” Nope. Not in this case. If the cost were a fixed dollar amount, that would be true. (Because then what we’re doing is subtraction. And once you mix subtraction in with a bunch of multiplication, the order becomes important.) Paying $10,000 today is worse than paying $10,000 several years from now.

But the tax on a distribution from a retirement account is not a fixed dollar amount. It’s a percentage. Paying 20% now vs. 20% later really does not matter. (Again, see our two bullet point options above. They’re the same.)

The Roth conversion question is generally just about whether you can pay a lower percentage now than you would pay later. If so, a Roth conversion is advantageous. And that would be true even if you planned to take the money out of the account next year (assuming, that is, that you’re at least age 59.5, so we don’t have to worry about the Roth conversion 5-year rule).

Again, we can just try the math for ourselves to demonstrate. Imagine it’s again a $50,000 amount you’re considering converting. And imagine that you have a 15% marginal tax rate this year, and a 25% tax rate next year.

If you do a Roth conversion, the after-tax amount is: $50,000 x 0.85 x the return over the next year.

And if you don’t do a Roth conversion (and instead take the money out of the account next year) the after-tax amount is: $50,000 x return over the next year x 0.75.

No matter what you plug in for the return, the first option is better. No need for the money to be in the account for a given length of time. (Again this is assuming that you’re at least age 59.5. Otherwise we have the Roth conversion 5-year rule to consider.)

When Breakeven Analysis Does Apply to Roth Conversions

As noted above, if the tax rate you would pay on a conversion is lower than the tax rate you would pay when the money comes out of the account later, a Roth conversion is advantageous. But there’s one case in which it can make sense to do a Roth conversion even when your current marginal tax rate is slightly higher than the marginal tax rate you expect to face later. Specifically, that can occur if you aren’t paying the tax out of the IRA but rather paying the tax out of assets you have in a taxable account.

And that’s when a breakeven analysis could apply. Because in that case, we’re no longer multiplying the IRA assets by a given figure, to represent the tax paid on the conversion. Instead, the entire amount taken out of the traditional IRA is going into the Roth IRA. And you’re paying the tax from somewhere else. (Effectively, you’re using taxable assets to “buy more” Roth IRA space.) And whether it makes sense to do that depends on a whole bunch of things, one of which is the length of time that the money will stay in the Roth (i.e., how long do you get to benefit from the tax-free growth that the assets will now experience, because they’re no longer in a taxable account). Other factors that are relevant in such a situation include:

  • What rate of return you anticipate earning on the assets,
  • What rate of tax you would have to pay on that return (and when you would have to pay it), if the assets stayed in a taxable account,
  • What (if any) tax cost is incurred as a result of selling the taxable assets in question now in order to use that money to pay the tax on the conversion.

But if I’m being honest, I would be reluctant to recommend a conversion to anybody if they’re paying a higher rate of tax on the conversion than they expect to face in the future, even if a breakeven sort of analysis showed that it might ultimately be advantageous. In most cases, I think it’s best to simply compare the tax rates, and if the current marginal tax rate is lower than the anticipated future marginal tax rate, a conversion is advantageous. And if you’re paying the tax out of taxable assets, then, great, it’s a little bit more advantageous.

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Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Investing Blog Roundup, Book Recommendation: Retirement Planning Guidebook by Wade Pfau

Today I just want to recommend a new book that I recently read: Wade Pfau’s Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success.

If you think of books about retirement planning as existing somewhere along a spectrum of brevity-vs-comprehensiveness, my book Can I Retire is at one extreme (very concise) while Pfau’s Retirement Planning Guidebook is at the other (very comprehensive).

To be clear though, just because it is a long book does not mean that it’s hard to read. Pfau digs into the nitty gritty details, but he manages to keep the explanations clear — often by walking you through hypothetical examples so that you can see how the decision process should work, step-by-step.

I highly recommend it for anybody taking a DIY approach to retirement planning.

Recommended Reading

Thanks for reading!

Which Dollars to Spend First Every Year in Retirement

There’s a common refrain in retirement planning that you want to spend from tax-deferred accounts when your marginal tax rate is low (as is often the case in years after you retire but before Social Security and RMDs kick in). It’s true that it’s better to spend from tax-deferred accounts than from Roth accounts when your tax rate is low. But there are other dollars that you want to spend first every year.

Let’s consider an example. Imagine that, in a given month, you’re trying to decide from which account to draw your next $1,000 of spending. And let’s also imagine that, so far this year, your taxable income has not yet fully offset your standard deduction and credits for the year. In other words, you currently have a marginal tax rate of 0%.

The obvious approach — let’s call it Option A — is to take the $1,000 out of your traditional IRA. Option A sounds pretty good, because this would be a tax-deferred distribution that’s completely tax-free. That sounds like as a good a time as any to spend from a traditional IRA, right?

Probably not. Because there’s likely an Option B: spend $1,000 from your regular taxable checking account, and do a $1,000 Roth conversion.

In each case:

  • You have spent $1,000,
  • You have removed $1,000 from your traditional IRA, and
  • You have incurred no tax bill.

But with Option A the remaining $1,000 is in your taxable checking account, whereas with Option B the remaining $1,000 is now in a Roth IRA. In almost every case, you’d rather have $1,000 in a Roth IRA than in a taxable account, because further earnings in the Roth will generally be tax-free.

The point here is that, if you have taxable-account assets that you can spend without generating any tax cost, it makes sense to spend those assets before spending retirement account assets. And if, when following such a plan, you have low-tax-rate space in a given year that you wouldn’t otherwise be using up, you can fill that space with Roth conversions.

In other words, every year before spending any dollars from retirement accounts (other than RMDs), you first want to spend from:

  • Earned income (i.e., wages, self-employment income),
  • Social Security income,
  • Pension/annuity income,
  • Interest and dividends from holdings in taxable accounts (note that this includes taxable and tax-exempt interest, as well as qualified and nonqualified dividends),
  • RMDs from tax-deferred accounts, and
  • Assets in taxable accounts that have basis at least equal to the current market value.

Again, the key thing that everything on that list has in common is that there’s no further tax-cost associated with spending these dollars. You have likely had to pay taxes on these dollars, but you don’t have to pay any more tax a result of spending these dollars.

Also, to be clear, this is not a discussion of how much to spend each year. For some people, it does not make sense to spend all of those dollars every year (so some dollars will get reinvested). And for other people, the intended total level of spending exceeds the categories above, so it then becomes a question of whether to spend from tax-deferred accounts, spend from Roth accounts, or liquidate taxable assets for which there would be a tax cost.

Retiring Soon? Pick Up a Copy of My Book:

Can I Retire Cover

Can I Retire? Managing a Retirement Portfolio Explained in 100 Pages or Less

Topics Covered in the Book:
  • How to calculate how much you’ll need saved before you can retire,
  • How to minimize the risk of outliving your money,
  • How to choose which accounts (Roth vs. traditional IRA vs. taxable) to withdraw from each year,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"Hands down the best overview of what it takes to truly retire that I've ever read. In jargon free English, this gem of a book nails the key issues."

Investing Blog Roundup: Pay Attention to Marginal Tax Rates and Not Tax Brackets

In so many tax planning decisions (e.g., which type of retirement account to contribute to, which account(s) to spend from each year in retirement, whether to do Roth conversions, etc.), you need to know your marginal tax rate.

And, long-time readers are surely sick of hearing me say this, but your marginal tax rate is often different than just your tax bracket. Especially for somebody in retirement, doing tax planning by looking at just tax brackets is as likely to be harmful as helpful.

In an article for Advisor Perspectives this week, William Reichenstein walks readers through a variety of cases in which this distinction is important, and he points out that even respected professionals make this mistake sometimes.

Recommended Reading

Thanks for reading!

Financial Advisor Licenses and Designations

A reader writes in, asking:

“I’m looking into using a financial advisor for the first time as I near retirement. I know I’m supposed to look for a ‘fee only fiduciary’ but am lost as to the titles…RIA, CFP, CFA, etc. I am not sure the pros and cons of each. Perhaps you could elaborate in an article?”

The first thing that confuses (and surprises) many people is that the term financial advisor doesn’t have any legal meaning at all. Basically anybody can refer to themselves as a financial advisor. A person who refers to himself or herself as a financial advisor might, from a regulatory perspective, actually be any of a few different things: an investment adviser representative, an insurance agent, a registered representative, or none of the above.

Registered Investment Adviser (RIA)

A registered investment adviser (RIA) is an entity (either a person or a business) that provides investment advice for a fee. A investment adviser representative (IAR) is a person who works for an RIA and provides advice on behalf of the RIA. For example, Wealth Logic, LLC is a registered investment adviser, and Allan Roth is an investment adviser representative who provides advice on behalf of the firm. Similarly, Jon Luskin, LLC is an RIA, while Jon Luskin (i.e., the actual person) is an IAR who provides advice on behalf of the firm.

Registered investment advisers (and representatives thereof) have a fiduciary duty to their clients. That is, they’re required by law to put the client’s interests ahead of their own. Unfortunately, the reality is that there are some RIAs who do not actually live up to a fiduciary standard. So a certain level of self-education is still necessary, in order for you to be able to understand what the advisor is recommending and why.

Another noteworthy point here is that you don’t actually have to be an RIA (or representative of one) in order to provide investment advice. For example, if you’re a cardiologist and your sibling comes to you asking for investment advice, you’re perfectly allowed to provide that advice.

The general rule is that anybody who is in the business of providing investment advice in exchange for compensation must be an RIA (or IAR). But there are exceptions even to that.

Registered Representative

A registered representative (also known as a broker or stockbroker) is somebody who sells securities on behalf of a broker-dealer (i.e., a brokerage firm). Registered representatives are generally paid a commission. They do not (usually) have to be RIAs because the advice is considered to be solely incidental to the business as a broker (i.e., the business of selling securities).

Registered representatives are held only to a “suitability” standard. That is, they are not required to put the client’s interests first. The only thing that is required is that they must have reason to think that the product they are selling is “suitable” for the client. And if history is a guide, all sorts of garbage can be considered suitable.

When you see, “securities offered by….” on a website or other piece of marketing material, you know that you’re dealing with a registered representative.

Certified Financial Planner (CFP)

The certified financial planner (CFP) designation is not actually a license. The entity that provides this designation (Certified Financial Planner Board of Standards, Inc, generally just referred to as the “CFP Board”) is a private entity rather than a governmental entity.

From a legal standpoint, all this designation means is that the person is allowed to use the registered trademark “CFP professional” to describe himself/herself and use the registered trademark “CFP” letters after their name.

So from a legal standpoint, this designation is not important at all. That is, there’s no service that you might want for which it’s legally necessary for the service provider to be a CFP. However, it is relevant information from a credibility standpoint, because it means that the person a) has passed an exam that covers quite a bit of financial planning material and b) has a meaningful amount of experience providing one or more financial planning services.

Certified Public Accountant (CPA)

The certified public accountant (CPA) designation is a license (at the state level). But, roughly speaking, the only things that CPAs are allowed to do which other people are not allowed to do are:

  1. Provide auditing (or similar) services, and
  2. Use the “CPA” letters.

So, as with the CFP designation, if you’re looking for personal financial services, it’s unlikely that you need somebody who is a CPA. But, as with the CFP designation, the CPA designation can be quite relevant, as it means that the person has a certain level of expertise with tax and other financial topics.

The personal financial specialist (PFS) credential is an additional designation (through the AICPA) that CPAs can get, which is akin to the CFP credential in that it means that the person has passed a test about personal financial planning and has a certain amount of experience with financial planning. But as with the CFP designation, it’s not a license from a governmental entity. It just means you’re allowed to use certain letters after your name.

Chartered Financial Analyst (CFA)

The chartered financial analyst (CFA) designation is akin to the CFP designation in that it is not a license to practice, but rather a designation from a private entity. So again it’s a situation where there’s no service for which you would need somebody who is a CFA, but it is a useful indication of a person’s experience and expertise.

Whereas the CFP area of focus is overall personal financial planning, the CFA curriculum and exams focus much more specifically and deeply on the investment side of things.

What Type of Professional is Right for You?

An important point to understand is that somebody can work in more than one of the above roles. For example, it’s common to see people who are both IARs and registered representatives. That is, they provide advice for a fee, and they also sell products for a commission. And that person might have one or more of the CPA/CFP/CFA designations — or none of them.

Are you looking for overall financial planning? Then you probably want to work with somebody who is an RIA (or representative thereof). The CFP designation (or the CPA/PFS designation) would be great to see. But it isn’t entirely necessary. For example, you might find a CFA who has also developed the necessary expertise in taxation, retirement planning, etc.

Are you looking specifically for somebody to do a certain type of tax planning for you? Then a CPA would likely be a good fit. But a CFP could be a great choice as well, if they happen to specialize in that particular area.

And of course in some related areas — estate planning, for instance — the best professional to work with is probably an attorney.

And finally, just because somebody has the right designation(s) doesn’t mean they’re a good fit for what you need. Compensation matters as well. For instance, if you’re looking for a one-time engagement, you will want to find a professional who usually works in such a manner, rather than a professional who prefers to work with clients who have ongoing needs and who are happy to pay an ongoing annual fee.

Investing Blog Roundup: Interviewing the Vanguard Total Stock Fund Manager

For the Bogleheads on Investing podcast, Rick Ferri recently interviewed Gerry O’Reilly (manager of the Vanguard Total Stock Market Index Fund and ETF) and Rich Powers (Head of ETF and Index Product Management at Vanguard). It was quite a discussion, covering a range of nitty gritty details about how the fund is run.

Recommended Reading

Thanks for reading!

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