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.

In its most worrisome finding, Fidelity found that half of the advisers’ clients planned to pay the conversion tax from the converted funds, ensuring the Roth will start out smaller than the previous IRA. It is difficult, and in some cases nearly impossible, for the Roth to outperform the old IRA if it starts with this disadvantage.

Most experts caution that the tax must be paid from other sources, so the Roth starts at the same size as the traditional IRA.

The BankingMyWay Roth Conversion Calculator figures possible investment outcomes of converting to a Roth versus keeping the traditional IRA. It also looks at what might happen if the investor kept the old IRA and invested in a taxable account the money that would be spent on taxes if the conversion were done. In many cases, this is the most profitable option.

Fidelity says it has seen a big jump in clients seeking information about conversions. That’s probably because a previous rule, permitting conversions only by households with less than $100,000 in annual income, was lifted so recently. Also, the tax bill can be divided between 2011 and 2012 if the conversion is done this year. In the future, the entire bill will be owed in the year of the conversion.

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