The issues aren’t quite the same as those one faces when considering the deepest aspects of personal faith and religious doctrine, but a “Roth conversion” can pose some difficult issues for investors nonetheless. And we’re going to hear much more about this going forward because of a scheduled change in the law: Unless something unexpected happens in D.C., come 2010 there will no longer be income limits on Roth IRA conversions.
There will be a lot written on the issue of whether one should convert or not, as well as endless articles describing all kinds of “strategies” to potentially leverage the change (some legitimate and others more questionable). For me, three things are important in considering this kind of “conversion”:
1. First and foremost is how strongly you feel about your future income tax rates. If you feel strongly that there is a significant chance your income tax rates will be higher in the future, then having some money in a Roth allows you to “hedge” that risk by paying taxes at today’s rates. Of course, you should note that while the Roth rules currently stipulate that no income taxes are owed on qualified Roth withdrawals, tax laws can change. So while the Roth clearly offers some protection from taxes, it’s not an ironclad guarantee.
2. Second is that you have to recognize that $1 of after-tax wealth is more than $1 of before-tax wealth. What this means is that by converting a $10,000 pre-tax IRA to a $10,000 post-tax Roth IRA, you have effectively put more resources into your IRA account. An example: If your income tax rate is 25%, your $10,000 pre-tax IRA is worth $7,500 of goods and services. Your $10,000 post-tax Roth is worth $10,000 of goods and services. In other words, even if the dollar amounts in traditional and Roth accounts are the same, the Roth gives you an ongoing tax break on “more” wealth. This is why, to properly compare the tax advantages of the two dollar-for-dollar, most quantitative analyses of Roth versus traditional—including Vanguard’s—include a taxable “balancing account” along with the traditional IRA. What you see is that if tax rates don’t change over time, the two IRAs actually offer identical tax benefits per dollar of after-tax IRA wealth. It’s just that you can generally get more after-tax wealth into a Roth. In practice, most people in the real world aren’t going to set up an additional savings account alongside their traditional IRA. So a Roth conversion is a great chance to save more, assuming you can pay the taxes you’ll owe on the conversion from a source other than the converted IRA.
3. A last consideration is how focused you are on spending the money in retirement. A big advantage of a Roth IRA is that you don’t have to take minimum distributions in your lifetime. That means you can keep the money in the “tax-free” wrapper a very long time. This is less of an advantage if you see yourself spending regularly from your IRA in retirement.
Obviously, everyone should consult a tax advisor about his or her own situation. But a Roth conversion in 2010 could offer some significant benefits to a lot of investors. And in all the noise and “strategizing” you’re going to hear in upcoming months, it may be important to stay focused on the basic issues.