The year of the Roth
Converting to a Roth IRA doesn't eliminate uncertainty about future tax rates.
As most of you know, 2010 is a special year for taxes. It is the last year covered by the Bush tax cuts which, as you may remember, were engineered as a package of temporary adjustments and deals rather than permanent changes. Most of it goes poof on Dec. 31 of this year.
In the meantime, 2010 is a special year for converting traditional IRAs into Roths. When the Bush cuts were being constructed there was a need to find more government revenue, particularly at the end of the period covered by the law, i.e., 2010. IRA conversions fit the bill because, in the short run, they generate additional income tax revenue. (In the long run they do not, since conversions reduce income taxes paid in the future.)
So as of a few days ago, the income limitation on conversion to a Roth is gone. And just to get things started with a bang, for 2010 only, you have the option to defer the income tax bill on the conversion to 2011 and 2012. (That is, it is split between those two tax years.)
Predictably, the arrival of 2010 has brought a flurry of interest in IRA conversions in the mainstream and not-so-mainstream media. And I have to admit that the coverage has been more accurate and helpful than I expected. But then my expectations were pretty low. I first started writing on this topic back in March, mostly because so many others kept getting it wrong.
Today, most discussions (for example, this one in The New York Times) put comparing income tax rates now and when retired front and center as the key issue. That is the fundamental question when choosing between the two types of IRAs and it should be the primary concern when considering a conversion from traditional to Roth.
But there is still a lot of fuzzy-headedness out there on IRA conversions. Ed Slott, author of the newsletter Ed Slott’s IRA Advisor and apparently the go-to guy for IRA quotes for both the Times and The Wall Street Journal, recently answered questions on the Times’ Bucks blog.
Q. Wouldn’t my retirement tax rate always be lower than my current tax rate as I am employed now, but not employed in retirement? Could you please provide a situation where this would not be true? Posted by D. Snipes, New York, N.Y.
A. Not necessarily, but only you will know for sure. If you truly believe that you will be in a lower tax rate in retirement, then a Roth conversion might not be right for you, but you don’t know what future tax rates will be, even at lower income levels. The Roth IRA conversion removes the uncertainty of what future tax rates will be.
The question is phrased a little more confrontationally than a non-Manhattanite might have put it, but it is a reasonable one. Generally income, if not standard of living, goes down in retirement. And, generally, that suggests that if tax rates are going to be different in retirement, they will be lower. It could happen.
Apparently Slott doesn’t handle mild hostility well. (His full answer is much longer. I’ve only quoted the first bit.) If you "truly believe" your tax rate will be lower in retirement it is almost a mortal lock that a Roth conversion is a bad idea, not "might not be right for you."
And in what sense can doing a conversion remove "the uncertainty of what future tax rates will be"? This is obviously literally untrue. And only in a narrow psychological sense does it reduce the worry that tax rates will go up. Yes, if you convert you will lock in the current rate (assuming you decline the 2011/2012 deferral option) and will therefore be unaffected by a possible higher rate in retirement. But that doesn’t mean you won’t have been worse off if rates turn out to be lower.
Either way you are making a bet with a lot of your money. Saying that converting will reduce fear and uncertainty is like saying that betting on black will reduce your fear and uncertainty that the roulette ball might not land on red. Actually, it’s worse. The premise of the question is that if you had to guess you would say that you expect tax rates to be lower in retirement. Converting anyway is swapping a good bet for a bad one because the good one is too scary.
The year 2010 is still less than two weeks old. It’s possible that the level of commentary on IRA conversions will improve as the year progresses. It could happen.
Related reading at Bad Money Advice:
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