Are Investors Erring on Roth Conversions?

Fidelity Investments has found a “surge” in investor interest in Roth conversions, as many more become eligible with the Jan. 1 lifting of income limits. About a third of those covered by Fidelity’s survey are expected to complete conversions by the end of the year, with four times as many conversions done this January compared to last year.

But are these investors doing the right thing? The survey suggests many are guided by an assumption, which may or may not be true, that their tax rates will go up. And many are planning to pay tax bills out of the converted accounts, negating any benefit the conversion might bring.

The poll of 500 investment advisers found the advisers believe 43% of their clients would benefit by converting their traditional IRAs, which are tax-deferred, into tax-free Roths. To complete a conversion, the investor must pay tax on the old account’s investment gains and tax-deductible contributions.

But the advisers' views largely depend on the assumption, held by 66%, that income tax rates will rise in the future. By converting now, an investor could pay tax at today’s lower rate to avoid a higher rate later. An investor would face a higher rate if the tax laws change or the investor’s income rises.

With the government running big budget deficits, there would seem to be a better chance rates will rise than fall. But there’s no way to know if that will really be the case 10, 20 or 30 years from now, when today’s investor withdraws IRA funds.

Historically, most peoples’ incomes fall in retirement, leaving them in lower tax brackets. If that happens, the conversion could backfire, as the investor would pay tax at today’s higher rate rather than the lower rate later. It could take a substantial rise in tax rates to leave an investor in a higher bracket even after a significant decline in income.