Devil’s Advocate-Roth and Conversions to Roth
Contributions to Roth IRA’s and any conversions to Roth are taxed upfront. As of now providing the guidelines are followed, earnings are not taxable. However, as our national debt continues to grow, is is not possible for a future congress to change the rules and declare the withdrawals of earnings are now taxable? Rules have been changed before!
Permalink Submitted by Alan Spross on Sun, 2010-02-14 18:57
Anything is possible in a worse case scenario, but this would be a flagrant and retroactive change in rules to a degree rarely if ever seen. It is far different than whether LT cap gain rates are capped at 15 , 20 or 25%. The entire premise of the Roth IRA is that your earnings will be tax free if you follow the rules, so any change in that would be a bait and switch of the worst possible kind, as well as being politically toxic. Breaking of faith with taxpayers would also be much enhanced by the fact that the 2010 Roth conversion rules encourages conversions with percs not seen since 1998, including elimination of the income limits.
That said, there is a precedent of ending unaffordable tax provisions by elimination of additional liabilities going forward. Grandfathering existing Roth IRAs and not allowing new contributions to those grandfathered accounts would not be nearly as flagrant as ending tax free treatment on prior contributions. This is unlikely also, but not as unlikely as taxing current Roths.
Taxing Roths also flys in the face of the current short sighted approach of not acting on future deficits in favor of current wants. A Roth conversion pretty much heads the list of tax revenue generators that are not politically unpopular and are actually viewed as a taxpayer benefit by all but the most strident deficit hawks.
We are now 12 years into Roth history, but the latest numbers only show that about 6% of IRA assets are in Roths. The vast majority of taxpayers are still looking for the lowest current year tax bill, so there is a natural aversion to conversions and even regular Roth contributions. While 2010 will be a huge year for Roth asset growth through large conversions from higher income taxpayers, I doubt that it will result in the Roth total reaching even 10%. So even deficit hawks should not be too alarmed about too many assets going into the Roth and loss of tax revenue a generation from now.
While most people underuse the Roth option, there are still some who overdo Roth conversions either by converting too much in a single year and paying too high a tax bill OR simply converting when they should not be converting because their tax rate in retirement will probably be lower than what they are paying for the conversion. A careful analysis should therefore be done before undertaking a conversion strategy, and it would not hurt to revisit that analysis at the recharacterization deadline either, since the benefit of a retroactive reversal of a conversion cannot be overstated.
Permalink Submitted by Bruce Steiner on Sun, 2010-02-14 22:09
It’s hard to predict future tax law, especially over the very long time over which an IRA owner and his/her beneficiaries can strecth it out. But just as converting is a decision, the benefit or detriment of which will depend on future tax law (and other factors), not converting is also a decision, the benefit or detriment of which will depend on future tax law (and other factors). All else being equal, if you think future income tax rates will be significantly lower than current income tax rates, that would cut against converting at this time.
Permalink Submitted by Alan Spross on Mon, 2010-02-15 00:05
In looking at the effectiveness of a Roth conversion, there is a huge amount of attention given to the present vrs future tax rate and/or tax structure comparison. Those factors will be applied by Congress to the population at large.
Perhaps a larger consideration that is implicitly buried in the future tax rate analysis is your own future success rate in accumulating retirement assets and thus landing in a given bracket. I think this part of the analysis is tougher for most people than the general outlook for tax rates. People have to factor in their tendency to save vrs spend, their exposure to risky investments, to expensive litigation, divorce, health related and uninsured natural catastrophes, and long term employment potential. Chances of receiving a meaningful inheritance is another factor. The range of outcomes in these areas can easily swamp the most accurate predictions of tax law. Your marginal rate could be increased by 5 points by Congress but by another 15 points or more by your own success in the above areas. Conversely, a bout of bad luck could leave you broke at retirement or in the 10% of 15% brackets. That would not be so good if you converted at 30%.
Therefore, if you look at the composite effects of govt policy and your own personal future predictions, most people would decide to hedge their bets and convert the portion of their retirement assets that strikes a middle ground and hedges against both success and failure in accumulating retirement assets.