Taxes and Roth conversions

Posted by on December 15, 2010 @ 2:10 pm in Taxes

Year-end is fast approaching, and based on web traffic it seems like the question of converting traditional IRA savings to Roth savings looms large. Congress has added to the buzz by allowing the conversion of certain pre-tax 401(k) money into Roth money (though few plans will offer this option in 2010).

Before you jump on the conversion bandwagon, I want to raise a critical question: What if tax rates don’t go up?

Conversion to Roth makes sense generally if you believe future tax rates in retirement will be higher than today’s. With looming fiscal challenges facing the U.S. government (as I’ve blogged about previously), the dominant assumption is that federal income tax rates will most certainly rise. But here’s another scenario. What if taxes go up—but tax rates fall?

Consider tax reform ideas from the President’s commission on deficit reduction. Those proposals envision a lower set of tax rates than today, although they raise tax dollars by phasing out various preferences. Other tax reformers have suggested raising revenues in other ways, such as a VAT tax, to close the fiscal gap, which leaves rates unaffected. Under these scenarios, taxes to the government might rise—but the marginal tax rate on retirement dollars might still be lower in retirement.

I’m not trying to dissuade investors worried about tax rate increases from converting today. But Roth advocates need to be cognizant that there is some risk, almost impossible to assess, that the conventional wisdom on taxes—higher marginal tax rates will be needed to address federal deficits—may be wrong. Your taxes can go up even while tax rates are lower. Or taxes can be increased in other ways. And it is the marginal income tax rate you pay that will dictate whether pre-tax or Roth savings make sense in the long run.

Our advice, in the face of this uncertainty, is tax diversification: maintain pools of pre-tax savings to hedge against falling rates, and Roth savings to hedge against rising rates.

A final thought: Roth conversions are complicated, so be sure to consult our content on vanguard.com, as well as your tax or financial adviser, to help think through the issue.

Note: If you take withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax on withdrawals. The amount you convert to a Roth IRA is not subject to the 10% penalty.

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