Thursday, December 24, 2009

The Time Value of Money and Roth IRA 2010 Converstions

The more I get into this discussion with clients, attorneys and accountants, the less clear the answers become. This post doesn't provide any answers, but starts a series of posts that should help in the discussion.

Richard Savoy, one of our senior trust attorneys pointed out, this change in Roth IRA eligibility was originally proposed by the government as a way to raise revenue - not as a way to simply provide a benefit to hardworking savers and investors. True, for certain people, converting makes sense, but there is a cost.

Take for example someone who is 50 years, working, and does not plan on taking any distributions until she turns 70 1/2, i.e. she has 20 years to go before needing the money. She has a significant traditional IRA, and is considering converting.

In the media, the conversion is a "no-brainer". Pay the tax today, let the account grow for 20 years, and enjoy tax-free withdrawals for the rest of her life.

But ignored in this conversation are two factors. First, even if she takes advantage of the deferred tax proposal in the bill (taxes paid on a conversion done in 2010 are due in two installments, in tax years 2011 and 2012), she is still paying taxes using today's money, not future funds. In other words, this calculation is ignoring the time value of money.

For example, let's just say she takes the funds to pay the tax due on the conversion from her municipal bond account. If the overall yield on the portfolio is 3% (using double-tax free municipal bonds), $100 invested at 3% for 20 years grows to $180 through compound interest. Paying the taxes today ignores this.

The second feature not considered is the simple fact that even moderate inflation rates over the next 20 years reduces the "value" of the funds used to pay taxes. In other words, let's just say inflation runs at 2% pa for the next 20 years. This means that the "real" (i.e., inflation-adjusted) value of a dollar would be nearly 50% less vs. today's value.