Roth IRA Conversion
Many “experts” are recommending conversion of TIRA to RIRA under the justified assumption (and fear) that tax rates would be going up. For those, like me, who are working and in 20-28% tax bracket, my financial analysis indicates that a) the conversion is not necessarily tax efficient and b) present value future tax increases is less than upfront payments during conversion. There is also some chatter that government may change policies in the future by either taxing RIRA or not raising tax rates. It seems that the best strategy is to only convert as much TIRA to RRIRA as to stay in the 15% or less tax bracket. Anyone have any thoughts or counter-points?
Permalink Submitted by Alan Spross on Mon, 2012-01-09 20:52
Experts also fail to emphasize that the conversion decision should not be made so much on what tax rates will or will not be, but on your assessment of your ability to accumulate tax deferred assets for retirement. If you are a saver, have good employment prospects and already have made some progress in establishing tax deferred assets, then measured conversions are a good way to hedge against the cost of distributing those assets via RMDs in retirement. Your tax rate has more to do with your taxable income than whether a given rate goes up a few points or not.
Congress may pass something like a VAT or restrict retirement contributions in some way, but existing Roth accounts would be grandfathered in the process. Congress is also somewhat addicted to the tax revenue generated by conversions as evidenced by the special incentive to convert in 2010. If future Roth contributions are restricted, it means the ones you can make before that happens are more valuable. Menas testing for govt benefits is also likely to be increased, but Congress is not going to renege on the promise of tax free distributions of earnings on prior Roth contributions. That would be political suicide and the most flagrant bait and switch you could imagine.
On the other hand, if you have an above average risk of divorce, poor health, or job loss exposures, then you might underplay conversions because you are more likely not to accumulate significant enough assets to increase your tax rate in retirement even if rates do rise.
Conversions are a hedge against the tax cost of success in accumulation, and retaining pre tax assets is a hedge against bad investment prospects and the other negative factors outlined above. Many people should never convert a penny. But for most, it is a matter of coming up with a plan of measured accumulation of Roth assets as a % of pre tax retirement savings. The trick is to determine the correct split and the prospects can change from year to year. Since the largest gap in tax rates is where the 15% bracket spills over to 25%, that presents a fairly valid cap for conversions and does make good sense for alot of middle income taxpayers that have some room in the 15% bracket for modest conversions each year.
Permalink Submitted by Bruce Steiner on Mon, 2012-01-09 23:13
While there are many factors to consider, the conversion is generally advantageous if the tax rate on the conversion is less than, the same as, or not “too much” higher than the tax rate that would otherwise apply to the IRA when the IRA owner or his/her beneficiaries would take distributions, but not if the tax rate on the conversion is “too much” higher than the tax rate that would otherwise apply to the distributions.
There are other benefits to the conversion besides the tax rate. If you pay the tax out of non-IRA money, you are effectively making a substantial additional contribution to your IRA. You avoid required distributions after age 70 1/2. You avoid the IRD problem in a decoupled state (or in any state if the state death tax credit returns) that the income tax deduction for estate taxes only applies to the Federal (but not the state) estate tax. You have a more valuable asset to fund a GST exempt disposition. If you (or your spouse) leave the IRA to the children in trust rather than outright (to keep it out of their estates, and to better protect against potential creditors, including spouses), you avoid the problem of trusts reaching the 35% bracket quickly.
No one knows what future tax rates will be. Over the time between now and when your beneficiaries have to finish taking the IRA benefits (which could be a very long time if you leave some or all of your IRA to or in trust for grandchildren), tax rates will change many times. Given the current budget situation, if I had to guess, I would guess that on average, future tax rates will be higher than current tax rates. But I understand the argument that future tax rates will be lower than current tax rates.
For specific advice, you may wish to consult with the attorney who handles your estate planning, who will know how this fits it to your overall planning.