2012 Roth IRA Conversion?

Nov 16, 2012 by

fortune teller with crystal ball

One way to forecast future tax rates.

Let me say first that this post is not intended to be a comprehensive guide to the decision of whether to convert any or all of your Traditional IRA to a Roth IRA. If you’re considering such a move, I suggest you hire a professional to analyze your options. The question is often complex and the answer highly dependent on your unique situation.

Predicting Tax Rates

The usual—and I think oversimplified—rule of thumb for informing the question of converting a Traditional IRA to a Roth IRA is this: Convert, and take the tax hit now, if you think you’ll be in a higher tax bracket when you withdraw IRA money than you are now; otherwise, don’t convert.

Your neighbors and colleagues and the punditry are talking about how taxes will be going up, if not on January 01, 2013 as we plunge off the fiscal cliff together then soon thereafter. With respect to your own Roth IRA conversion, that of course is not the question. The correct question should be: How will your tax rate in retirement compare to your tax rate now? The answer depends on far more than any tax code changes to which the Congress and President happen to agree. For example, the most important question is likely how your retirement income will compare to your current income.

All that aside, I don’t know about you, but I’m pretty lousy at predicting what politicians will do next week let alone over the next several decades. If you want to do as mutual fund managers do and rely on “past performance” charts to hint at the future, the fact is effective U.S. federal income tax rates have been declining steadily for 50 years. Are you thinking our elected leaders are prepared to reverse this trend given the federal government’s junk-status balance sheet?

Here’s the thing: Neither you nor I or the pundits are smart enough to predict reliably future tax rates. You’d do just as well consulting a Ouija board. Moreover, in my mind tax rates aren’t even the foremost issue when considering whether to convert a Traditional IRA to a Roth.

It’s Not the Tax Rate but the Taxable Income That Can Kill You

True story: A good friend of mine listened to his misguided financial advisor and converted in the summer of 2007 thousands of dollars worth of Traditional IRAs to Roth IRAs. When you convert to a Roth, you must pay income tax—at your marginal tax rate—on the current value of the converted Traditional IRA (less any basis you may have, if you’ve made non-deductible contributions). As it happens, equity markets, in which my friend’s IRAs were mostly invested, were at a peak in the summer of 2007, and so were his IRA investments. So he paid thousands of dollars in income tax when he filed his 2007 return on the lofty, if transient, value of his Traditional IRA on that particular sunny, summer of 2007 day when he converted to a Roth.

You probably see where this sad story is going. 2008 brought the meltdown. My friend’s Roth IRA equity investments plummeted in value by over 60%. Much of the value on which he’d just paid a huge lump sum in income tax had now evaporated—poof. And, like many, his investments have recovered only modestly. It may well be that he paid IRA conversion taxes in 2007 on “income” that he’ll never actually receive. Ouch.

Should You Convert to a Roth By December 31?

Based solely on their own forecast that tax rates are going up, many financial types are advocating Roth conversions before year’s end. I’m suggesting that there are more questions to consider in the Roth conversion decision than current vs. future tax rates.

For one: Is the value of whatever your Traditional IRA is invested in relatively high now so that you’d be paying a premium to Uncle Sam should you convert? If you’ve been invested in bonds, I can almost guarantee you that the value of your investment is way up, perhaps at or near a long-term high. And what if you’re invested in stocks? I haven’t the slightest idea whether stocks are now high, low, or in between. And guess what: Neither does anyone else. But if it turns out that stocks are relatively high now, by converting you’ll be paying tax, in advance, on income you may never see. I’d suggest that effect will likely be far more financially significant than the difference in your marginal tax rate today vs. when you retire.

Your Thoughts

Do you plan to do a Roth IRA conversion before December 31? If so, have you figured how much tax you’ll owe on April 15? What factors did you consider in making the conversion decision?

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