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Clarity Around The Roth IRA Conversion Question

As April 15 approaches, MoneyWatch is publishing daily tax tips. See the full list here, and please check back frequently for the latest advice from our experts.
There has been no shortage of articles on the subject of 2010 Roth conversions, and whether new money should be contributed to a Roth vehicle or a traditional IRA or 401K. Fellow columnist, Charlie Farrell, recommends you don't rush into Roth Conversions, while many others are urging conversion post haste to stay a step ahead of the tax rates that must go up in the future due to our deficit spending. Here's what I'm telling clients, as well as what I'm doing with my own portfolio.

The Roth conversion
A Roth conversion is simply taking part or all of your traditional IRA and changing it to a Roth. Since the traditional IRA is usually pretax money, the IRS wants its cut since you won't be paying any income tax when you withdraw the funds from a Roth vehicle. Thus, to convert, you've got to come up with the cash today, or at least within two years of conversion. The IRS is allowing taxpayers a one-time opportunity to spread out the payment of taxes due on a Roth conversion in 2010 over 2011 and 2012.

The decision simply comes down to deciding whether to pay the taxes now or whether to pay them when we withdraw the funds.
The simple math
Forget about those complex calculators or rules that you must keep the account open for ten years or longer for the conversion to be beneficial. The simple math reveals that if your marginal tax rate today is the same as the marginal tax bracket upon withdrawal, you will have EXACTLY the same amount of dollars after taxes no matter which you picked. Or, to put it another way:

  • You are better off converting now if you think your tax bracket will be higher upon retirement.
  • You are better off staying in the traditional vehicle if you think your tax bracket will be lower upon retirement.
Predicting the future is hard
Okay, I said the math was simple but I never said predicting tax rates and your taxable income upon retirement would be. Here are some things to consider.

Arguments for converting

  • You expect tax rates to be going way up.
  • You expect high income upon retirement.
  • You are in a low tax bracket today.
Arguments for staying put
  • You expect to have low income upon retirement.
  • You are in a high tax bracket today.
  • You think there is a chance of a consumption tax like the Fair Tax Act replacing income tax.
Where's the clarity I promised?
Since we can't answer these questions with any degree of certainty, it seems I have provided a whole lot of useless advice. Well things aren't always as they seem.

The fact that we can't answer these questions is precisely why we want to bet on both sides of this simple math. By diversifying against what Congress eventually decides, we provide ourselves with some protection from this huge uncertainty. That's why I recommend having some of your nest egg in both traditional and Roth vehicles.

Since Roth vehicles are relatively new compared to traditional pre-tax vehicles, this means most people have much smaller Roth's than they do traditional. Thus, I usually recommend new money be placed in your Roth 401K or IRA rather than traditional. Beyond that, I often recommend PARTIAL conversions over time to provide some tax diversification.

Unfortunately, there is nothing simple about taxes. Columnist Carla Fried notes some tax traps in her column, Beware of Roth IRA Conversion Pitfalls. So since diversifying into post-tax accounts is filled with these traps, I do recommend you seek professional tax advice if you think any of these apply to you.

The answer to the question of whether you should have traditional or Roth vehicles is crystal clear in my book. Most people need both to properly protect themselves from the future.

More Tax Tips
Beware Roth IRA Conversion Pitfalls Tax Tip: Cut Taxes for Your Heirs Tax Tip: How to Claim Home Buyer Credit Investor Tip: Focus on Tax Efficiency

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