Smart Roth, Dumb Roth

There you have the essence of smart Roth investing: 1) Don’t pay too much; 2) put the highest return asset you have into the Roth and hold on forever.

But you don’t have to be a billionaire venture capitalist to be a smart Roth investor.

Any affluent parent, as soon as their teenage child has W-2 income from waitressing or clearing tables, or as soon as their college student gets a paid internship, can open a Roth account for the child, contribute the earnings up to the $7,000 maximum, and put that Roth money into a broad, low-cost stock index fund.

These parents know the power of compound interest. At the U.S. stock market’s historical rate of return (7 percent real), and on the assumption the money is surplus for the child and won’t be touched through their lifetime, say, age 88, that money can be left to compound for 70 years. It will double about every decade, and 2 raised to the 7th power is 128. The $7,000 contribution has an expected ending real value of $800,000 to $900,000 (depending on whether the return was exactly 7 percent or a little more). Smart gift!

This is smart Roth, because the teenager’s marginal tax rate is zero or close, making the cost of electing the Roth option effectively zero. And the college student doesn’t need the money, immediately or perhaps ever, because, if the folks were affluent enough to gift $7,000 to their Roth, then college is likely already paid for too.

Dumb Roth

Take the same college student, but remove the affluent folks. Bob takes out an extra $7,000 in student loans to fund his Roth. Bad move. Principal and interest on the loan, paid back over the next 10 years, will offset most of the Roth value, the more so if the stock market goes through one of its periodic decade-long swoons.

Dumb Roth means paying too much for the privilege. Later, when our not-so-affluent college student has employment, he can contribute the extra student loan payments he’s not making to a newly opened Roth account. He’ll miss a few years of compounding, but not many.

Unless… he has a really good job, and the question concerns whether to open a regular or Roth 401(k) account. When we hear that “young people” should favor a Roth 401(k) over a traditional, deductible 401(k), we want to scream.

Allow us to introduce one of our young nieces, Rosy Kalkulus. She’s fresh out of a master’s in statistics, 25 years old, and works as a machine learning engineer in Silicon Valley. Her salary is $155,000, with a bonus of $25,000 and a stock award of $100,000. That’s what they pay young people with the right skill set nowadays.

Rosy is in the 35% Federal bracket and 9.3% California bracket, for a combined marginal tax rate of 44.3%. Young though she be, Rosy absolutely, positively needs to max out her traditional 401(k) option first. That $23,500 only costs her $13,089 of foregone consumption, courtesy of deducting the contribution at 44.3%. And the odds that her tax rate after age 75 will be higher than 44.3% are low — the more so if she retires in Washington or Nevada, with no state income tax.

Nonetheless, given her compensation, Rosy should save more for her retirement and should do it under the Roth umbrella. Smart as she is, she proceeds to do a backdoor Roth and a mega-backdoor Roth. She’s been advised not to accumulate too much in her taxable account, beyond her emergency fund and future down payment, because she also pays Net Investment Income Tax, for a marginal tax rate on bond interest or bank accounts of 35% + 9.3% + 3.8% = 48.1%. Plus, in California, she’ll pay 28.1 percent on any qualified dividends.

Accordingly, Rosy opens a non-deductible IRA with $7,000 and immediately converts it to a Roth IRA, using the handy button on the broker’s web site. Her employer, like many in the tech industry, has also made it easy to convert automatically each after-tax 401(k) contribution into a Roth 401(k). Allowing for employer matching contributions, she should be able to contribute another $40,000 while staying within the total 401(k) limit for 2025.

Result: she’ll save over $70,000 per year toward retirement beginning here at age 25, about two-thirds of it under the Roth shelter. That’s certainly thrifty, but is only about 25% of her gross income, not unreasonable for a graduate who didn’t go wild with a new cherry red BMW convertible, plus has no kids and no mortgage (and no student loans, since she had the aforementioned affluent parents.)

And she didn’t pay a penny for the Roth privilege because she maxed out her deductible 401(k) first. That’s smart Roth.

Dumb and Dumber

The essence of dumb is to pay a lot of money for the privilege of moving money under the Roth shelter. Which brings us to Roth conversions.

The first thing to understand: Whenever the Federal government changes the law to replace regular retirement options with Roth options, the Joint Committee on Taxation, which scores tax provisions for their revenue impact, records the switch to Roth as a positive for government revenue.

Think about that: The government records new Roth provisions as a revenue gain. You think you are paying tax on the conversion now, to save more tax later. The government thinks it gains when you think that way.

On what grounds could the government possibly score tax-free-forever accounts as a gain?

It’s obvious: If you convert $100,000 from your traditional 401(k) while in the 24% bracket, you pay $24,000 to the government today, all of it at once, in a lump sum. You betcha the government likes that!

Of course, in your mind the upfront tax payment is an investment. You are staring at substantial RMDs coming soon. If you don’t do that $100,000 Roth conversion, your first RMD is going to be …. wait for it … $3,774 higher than otherwise. At 24%, you’d have to pay $906 on that un-averted RMD. Or, if the Big Beautiful Bill had failed and the 2017 Trump tax cuts expired at the end of 2025, the tax would be 28%, or $1,057.

Who wouldn’t jump at the chance to pay $24,000 now to avoid spreading out the payments at $1,000 a year for the next two decades?

Oops. That came out wrong. Try this: “What taxing authority would not jump at the chance to receive $24,000 in hand, as opposed to waiting for that same amount to dribble in over decades?”

And since the Big Beautiful Bill did pass, extending the 24% rate, our erstwhile converter will have made a $24,000 interest-free loan to the government, paid back over decades in a slow dripof RMD taxes averted. With no gain at all in net present value terms. Don’t forget the commutative property of multiplication from junior high algebra: If the tax rate doesn’t change, it doesn’t matter whether you take the tax haircut at the conversion or upon distribution. There’s no gain under a constant rate.

And what if a future Congress lowers taxes further, as occurred in 2003 and 2017, bringing the new tax rate in this bracket down to 21% beginning, say, 2029?

Dumber! Now the conversion will lose money, bleeding year after year, as you paid 24% upfront to save on tax at 21% due in dribs and drabs over decades.

Whoa — Not So Fast!

Hey bud — that $100,000 moved into the Roth doesn’t just sit there, it earns 10% in the stock market. And the second year RMD percent is 3.92%, making that second RMD on the appreciated account $4,312. At 28%, that is $1,207 in tax averted by reducing your RMDs through conversion. And the dollar amount of tax saved will climb rapidly from there as your stock portfolio goes up and up!

Excellent point: We should be dealing in the future value of funds, not fixating on the initial $100,000 amount converted here in 2025. But sauce for the goose is sauce for the gander. That $24,000 paid over to the government today has a future value too. It could have been left in the traditional account, invested in stock, and also appreciated 10%, to $26,400, then $29,040, etc.

Future value has to be netted against future value. We say again, the payoff from a conversion designed to reduce RMDs will take decades.

Make no mistake: If the tax rate on your future RMDs does increase to 28% and stays there for decades, and you converted $100,000 today at 24%, the expected net present value of the conversion is positive, at $4,000. But you book that gain RMD by RMD, year by year, and only if the tax rate doesn’t change.

If taxes do ever drop, due to legislation or a change in taxpayer circumstances, back to the level at the time of conversion, then the payoff from the conversion stops. You gain only the value of the averted tax booked to that point. The rest of the conversion tax resumes its status as an interest-free loan to the government.

Two final points: If you’re the charitable type, you can donate up to $108,000 per year from a traditional IRA after age 70½, on which not a penny of tax has ever been paid. Or if, God forbid, you need medically necessary long-term care, much of that can also be deducted from your reported RMD income. In which case paying for a Roth conversion will have been really dumb.

Conclusion

We’ve come a long way from Peter Thiel. From saving a billion dollars in taxes, to saving $151 per year, over decades, by converting $100,000 at 24% now to avert taxation of RMDs at 28%. In the best case.

That’s 15 basis points on the $100,000.

Now remember, we have nothing against Roth accounts.

To prove it, let’s change the circumstances again. Suppose you are Rosy Kalkulus’ parents and she the only heir. Converting today at 24 percent means that decades later, she might not have to pay 44 percent on large sums withdrawn over 10 years under SECURE 2.0. Not so dumb.

Smart Roth means not paying too much, preferably zero, to shelter surplus funds you don’t plan to spend in your lifetime.

Put it on a T-shirt: Roth for our heirs — not us.

Edward F. McQuarrie, Ph.D., is Professor Emeritus at Santa Clara University. He writes about financial history and its implications for retirement planning. Working papers describing his research can be downloaded at https://ssrn.com/author=340720.

William J. Bernstein is a neurologist, the co-founder of Efficient Frontier Advisors, an investment management firm, and a writer with several titles on finance and economic history. He has contributed to the peer-reviewed finance literature and has written for several national publications, including Money Magazine and The Wall Street Journal. He has produced several finance titles, and four volumes of history, The Birth of Plenty, A Splendid Exchange, Masters of the Word, and The Delusions of Crowds about, respectively, the economic growth inflection of the early 19th century, the history of world trade, the effects of access to technology on human relations and politics, and financial and religious mass manias. He was also the 2017 winner of the James R. Vertin Award from the CFA Institute.

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