By Terry Coxon, Casey Research
It's clear to me, even though it may not be clear to you, that unless there is something very unusual about your situation, if you have a traditional IRA, you should pay the tax now and convert it to a Roth IRA. Not just maybe, but definitely. Not just for a small advantage but for a big one. If you don't convert today, you'll ultimately surrender much more to the tax collector. You'll be throwing money away. And you'll keep throwing it away. It's a result neither of us wants.
Your IRA is an object in motion, with money going in and out of it and investments turning over inside of it. It lives not just on your brokerage statement but across the years of your calendar as well. That's why the Roth conversion question can seem so tangled. Because of the time dimension, deciding whether to convert isn't as simple as deciding whether to replace one stock with another. But there is, as I'll try to show, a way to look at the question that cuts through the complexity.
With a traditional IRA, you are allowed to contribute $5,000 per year of employment income (or $6,000 if you are 51 or older), and, if your income isn't too high, you receive a tax deduction for the contribution. Earnings inside the IRA accumulate and compound free of current tax. Later, when you withdraw the money, it comes to you as taxable income (except to the extent of any contributions that weren't tax deductible when made, which come out tax free).
With a Roth IRA, if your income isn't too high, you may contribute up to the same $5,000 or $6,000 per year, but none of it is tax deductible. Just as with a traditional IRA, earnings inside the Roth accumulate and compound free of current tax. When the money comes out, assuming you are at least 59.5 years old and the IRA is at least five years old, the money goes tax free straight to your pocket.
Whether traditional or Roth, any IRA's power to make you richer comes from tax-deferred compounding. Consider a simple example that compares an ordinary, taxable savings account with a traditional IRA. Assume, for the sake of simplicity, that: Continue reading "Doing the Roth Arithmetic" →