Since the dawn of 2010, there has been a lot of talk about the expiration of the Bush era tax cuts. Among the cuts is the disappearance of the $100,000 Roth conversion income limit for this year only. This means that you can opt to pay taxes on your traditional IRA balance over the next two years in exchange for tax free withdrawals during retirement. For months I have read article after article portraying this opportunity as an easy decision and sure way to save money on taxes, but in reality there are many changing variables that greatly affect the benefits to conversion.
The logic behind the conversion for investors is to pay taxes now at a sure rate before taxes increase. But today’s tax rates are not low and adding the additional income created from the conversion to a taxpayers ordinary income can easily push them into a much higher tax bracket. So why would someone volunteer to pay taxes now when they could be deferred to a later date?
There is no argument that it only makes sense to convert if you have funds available to pay the taxes outside of your IRA. Otherwise you would reduce the potential tax free growth on that amount, defeating the purpose of the conversion. But even if you have enough cash flow or taxable savings to pay the tax bill, you have to consider the opportunity cost of using that money to pay taxes when it could be invested and earning a return.
The decision to convert depends heavily on what your goals are with your IRA. If your primary goal is to leave as much money as possible to your heirs and you don’t need any IRA funds for your retirement, a Roth conversion is probably a good idea for you. You would escape the Required Minimum Distribution rules which require traditional IRA owners to take a minimum calculated amount from their IRA annually beginning at age 70 ½ and therefore pay taxes on those withdrawals. In addition, the benefit of tax free withdrawals is passed on to Roth IRA beneficiaries who then take the non-taxable withdrawals over their life expectancy.
For the rest of you who plan on using your IRA to at least partially fund your retirement, the decision requires a lot more thought. One big unknown factor that can greatly sway the results is life longevity. It can take many years to make up for the amount of taxes you have to pay now and the lost potential earnings on those dollars. This is where the opportunity cost arises. As an example, if you convert a $200,000 IRA, it can generate a combined federal and state tax bill as high as $80,000. Not only has your savings been reduced by $80,000, you also lose all the future earnings that that $80,000 could have ever made. In order for the conversion to be a good idea, the sum of the taxes not paid on Roth withdrawals would have to add up to more than the opportunity cost. The way the math works out, the longer your time horizon, the longer the Roth has to catch up. For this reason, if you are already retired or within a few years of retirement, it is unlikely that you’ll benefit from converting. If you live long enough to see it, the Roth IRA will eventually pull ahead of the traditional IRA, but this is assuming Roth withdrawals are never taxed.
This brings me to the last, and in my opinion, most important point I am going to make: what guarantee do we have that congress is not going to change the rules on tax free withdrawals from Roth IRAs down the road? Imagine this: 20 years down the road, the deficit is still huge, republicans and democrats are still fighting, and tax receipts from traditional IRAs are declining because the government in effect collected those back in 2010 through conversions. It is not inconceivable that they would look toward all these privileged retirees who have diligently saved and already paid taxes on their traditional IRAs and are withdrawing hundreds of thousands of dollars each year…tax free. That sounds like an easy place for the government to pocket some much needed revenue. Maybe it would be a good idea to means test the tax free benefit, only allowing those who withdraw under a certain amount each year to avoid taxes. We have certainly seen these sort of games played in the past (Social Security) and I wouldn’t put it past our government.
I don’t find it a coincidence that during these times of unprecedented deficit and uncontrollable federal spending, these conversions are so highly promoted, after all how rosy does an extra $662 billion in tax revenues look to the government? While I can see why it makes sense to covert to a Roth IRA in very specific situations, in most cases the cost and political risks just don’t seem to outweigh the benefits.
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