The Year of the Roth

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 1040 changes. Most of it goes poof on December 31st 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 IRA 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 I.R.A. 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 I.R.A. 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.

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.

No Comments

  • By Neil, January 12, 2010 @ 1:43 pm

    His answer isn’t wrong, just phrased in such a way as to convince people to take up his preconceived notion of the “right” choice. I understand why a lot of people are enamored with Roths – it’s because of the mentality that taxes are always bad. And, in the end, you will pay less taxes by converting to a Roth, guaranteed. The little detail that the difference between taxes paid under the two schemes is 100% made up for (assuming the same tax rate today as in retirement) by investment gains never earned in the Roth is moot – you are still sending less money to Uncle Sam.

    If you expect to retire into the same tax bracket as you currently inhabit, it’s probably not an unreasonable expectation that future tax rates will be higher. While tax increases are currently a political nightmare, there will have to come a breaking point where someone admits that current deficits are unsustainable, current tax rates are nowhere close to being in “laffer curve” territory, and tax rates will have to rise in order to continue to provide the government services that taxpayers expect.

    But, of course, this rise probably won’t be enough to make up for a change in tax bracket, and most middle-aged people can probably reasonably expect to retire in a lower bracket. So Roths become a bad idea.

  • By Steve, January 12, 2010 @ 3:36 pm

    Unless the US suddenly switches away from a progressive tax system, it will always be worth diversifying your taxability. As we (but not everyone seem to) know just because you are in the “25% tax bracket” does not mean that every dollar you make gets taxed at 25%.

  • By Kosmo @ The Casual Observer, January 12, 2010 @ 4:36 pm

    “because, in the short run, they generate additional income tax revenue”

    Here’s a way to generate more tax revenue in 2010. Sell “no taxes for the rest of your life” cards, based on some projection of future income. Bill Gates pay a few hundred million, and never has to fill out another 1040. Huge benefit for the government in the short run.

    (Yes, I’m joking. Mostly.)

  • By Craig, January 13, 2010 @ 6:15 pm

    It may be that I’m missing something here–hell, it’s almost certain I’m missing something here–but it seems to me that a very important consideration is how much of your retirement income is going to come from your IRA versus pensions, Social Security, part-time work, etc.

    You pay into an IRA with marginal dollars, but if you expect your IRA to provide the lion’s share of your taxable retirement income (as I do), the tax burden on an traditional IRA is going to be much closer to your _average_ tax rate than your full marginal rate. So someone who converts their entire IRA to a Roth this year is betting that taxes will go up so much that their average tax rate in retirement will exceed 35%, right? Because that’s probably what you’re paying on the margin for the privilege. (Today, you have to have about 2 and a half million in taxable income to get your average rate up past 34%.)

    I do put a bit of my money into a Roth, as a hedge against tax rates, but I think even that hedge is overstated. If Congress has to raise rates by 10 or 20 percent at some point in the future, do you really imagine they’re going to leave Roth balances untouched? I doubt it, myself. And the “Roth hedge” incurs risk in other ways, too: if usage fees and consumption taxes become a more important part of the tax landscape in decades to come, anyone who got their Income Tax locked in beforehand is likely to feel shortchanged.

  • By Mt, January 14, 2010 @ 12:10 am

    I think that the difference Craig is describing between marginal and average rate is a great point, and one that people often miss.

    Also consider that you might retire in another country, state, or locality – and your taxes could then be more different. One NY wage-earner who retires in FL might see a 10% overall tax-rate drop just from state and local taxes.

    And although the standard discussion about what the Federal Gov will do with the income tax rates (and which bracket you’ll be in) is relevant, and the expectation of rate increases is valid, it should always be noted that the Gov could pull needed revenue from a GST or VAT. Because so many countries do it that way.

    Meanwhile, don’t leave out the value of the fact that a Roth allows penalty-free withdrawals 5 years after it is established, and does not have any potential RMD penalties.

    Barring concrete knowledge that your retirement income tax rate will be higher, the utility of the Roth is limited. The Roth is really useful to those who are younger, have a relatively low marginal rate, and might need the money later on, up until there is a high enough balance that the value of penalty-free withdrawals diminishes. The other consideration for an older worker is if one already knows their Traditional RMDs will exceed their annual expenses.

    I really don’t get why Slott and others act like it’s a gift. I guess that if I had a large Traditional IRA and were totally unemployed, I would convert some of it now.

  • By Craig, January 15, 2010 @ 10:19 am

    Mt–Another good wrinkle. If I were out of work by necessity or choice (going back to school? spending two years in the Peace Corps?) conversion in 2010 might be very attractive to me. Someone, somewhere, is probably going to make out like a bandit on that deal.

  • By kitty, January 15, 2010 @ 6:17 pm

    “Someone, somewhere, is probably going to make out like a bandit on that deal.”

    People like me who have only non-deductible IRAs, will make out fine. I plan to convert all of mine very soon. Very little tax liability, probably don’t even need to bother deferring it.

    Plus, as I am likely not be able to contribute to Roth this year again especially as I plan to sell a little more of my ESPP stock (my income puts me in phase-out range, but with capital gains there it’ll easily be over), opening a non-deductible IRA and converting it to Roth immediately is a nice alternative.

    BTW – what is the logic behind removing income limit on conversions but keeping limit on new contributions? Anybody who isn’t able to open Roth, can just open an IRA and convert it shortly thereafter. Am I missing something?

    “Barring concrete knowledge that your retirement income tax rate will be higher, the utility of the Roth is limited.”
    It’s very useful to people who aren’t eligible for deductible IRAs.

  • By Daddy Paul, January 15, 2010 @ 11:04 pm

    My only concern with the Roth is that I believe taxes will go up but perhaps not income taxes. It appears DC is very happy to slap fees on anything.

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