Roth Conversion Confusion
If you’ve read the financial press lately, you’ve seen many articles trumpeting the benefits of converting traditional IRAs to Roth IRAs. The Roth conversion is the latest ‘hot idea’ in financial planning, because of a new provision in the tax laws to take effect January 1, 2010. This revision repeals the income limit and permits the tax bill to be spread over the two years following the conversion year. This change is undoubtedly a great opportunity for some people, but does it make sense for you?
The new law allows high-income wage earners to convert from a traditional IRA to a Roth IRA whereas they previously were prohibited due to a $100,000 income limitation. Thus, it only affects high wage earners. Converting to a Roth IRA has been available for many years as a technique for taxpayers below the $100,000 income level. By removing the income cap, the opportunity is now open to everyone. It’s ironic that the people who will be able to convert for the first time are in the worst position to take advantage of it. This is because a conversion is treated as a taxable distribution from the IRA, so high income taxpayers would pay a substantial tax upon conversion.
The benefits are intuitively appealing. Pay taxes now and never pay again. Who doesn’t think tax rates will be higher in the future than they are now? In general, tax rates probably will be higher, but that doesn’t mean yours will be.
Many people have more income now than they will have in the future. This is especially true for pre-retirees who are in their peak earning years and will be retiring in a few years on social security and investment income. If you are likely to drop to a lower tax-bracket when you retire, why pay at a higher rate now in order to save taxes later at a lower rate? The conversion idea sounds good on the surface, but you need to understand how it relates to your own situation.
A Roth conversion is most attractive when the future tax rate is expected to be higher than the current rate. However, your tax bracket is often not expected to change. In fact, if you were to convert too much money in one year, the additional taxable income could push you into the next higher tax bracket. In addition, social security recipients are taxed on their social security based on other sources of income. A Roth conversion (distribution) could make more of your social security income taxable, effectively raising your true marginal tax rate.
There are cases where conversion makes sense even when your tax bracket is expected to remain the same. I usually think of Roth money as the last money you will ever use. There are exceptions, but why would you take money out of a Roth IRA before other accounts if it is the most tax efficient account? Most of us will leave an estate when we die whether we intend to or not. Thus, Roth money is likely to be passed on to heirs. In that case, it’s the heir’s potential tax rate to consider. In many cases, it is likely to be substantially higher than your current rate, which makes the Roth option a good long-term estate planning strategy.
There are some cases where a Roth conversion is essential. I have some clients who have a zero tax rate, yet own a large IRA, so we are able to move a portion of their IRA to a Roth IRA each year and completely escape taxation. The money comes out of the IRA tax free (as long as you don’t convert too much) and will never be taxed in the future. If done a little each year, there is a huge potential tax savings.
Complicating the Roth conversion analysis is that we know the tax rate structure now, but we don’t know what it will be down the road. Rates for the wealthy could rise while lower bracket rates could stay the same or drop. Income taxes could be replaced or augmented with a sales tax or value added tax, which might completely change the decision dynamics. Although improbable, the government, if desperate enough for tax revenues, could renege on the deal and tax Roth money some day. The political climate and tax policies can change dramatically in just a few years and might shift several times during your retirement years.
When formulating tax strategies, I usually like to make decisions based on the current laws. However, it doesn’t hurt to make some assumptions about the future as long as you allow for the fact that you probably will be wrong! I have a hard time imagining that Roth money will ever be taxed, because of the potential political backlash. Even so, you never know for sure. For this reason, it’s a good idea to employ ‘tax diversification’ and maintain accounts with different tax treatment. For someone with everything in a regular IRA, conversion of some to a Roth IRA would provide additional flexibility.
You don’t have to convert an entire account. You can do a little at a time. In fact, rarely would someone want to convert a large IRA all at one time. With the financial impact of large taxable distributions in any one year, it is usually wise to perform only partial conversions.
The point of this article is that you need to exercise caution if you are considering a Roth conversion. It is important to understand the current tax impact and to make an assessment of your future tax situation. Since future tax laws are uncertain and your personal situation could also change over time, it would be wise to take small steps.
If you are still confused on what is best for your personal situation, please feel free to schedule a meeting to review your possibilities.