For many investors, deciding whether to convert to a Roth IRA hinges on a bet about future income-tax rates. But there’s another tax question that can slip by unnoticed: Will capital gains rates go up or down?
Conversion is most likely to pay if you assume your income tax bracket will be higher in retirement than when you convert. Although you would have to pay tax on the converted amount, you’d avoid a higher tax rate on withdrawals if you kept the traditional IRA. Roth withdrawals are tax-free.
The BankingMyWay.com Roth IRA Conversion Calculator shows three possible outcomes. First is the future size of your nest egg if you convert. Then is the projected size of your traditional IRA. Both calculations assume all taxes are paid.
The third calculation shows what your account could grow to if you stuck with the traditional IRA and also invested the money you save on current taxes by forgoing a conversion.
Since this money would be invested in an ordinary taxable account, it would be taxed. If it were invested in assets such as stocks or stock funds that produce most of their returns from long-term capital gains, profits would be taxed at no more than the long-term capital gains rate of 15%. Withdrawals from the traditional IRA would be taxed as income, currently at rates from 15% to 35% for most investors.But what if the capital gains rate changes? Over the past two decades, the maximum rate has fallen from 33% to 28% to 20% to today’s 15%. The most recent cut is scheduled to expire at the end of 2010, restoring the 20% rate, but Washington could change that. Given the big federal budget deficits, a rate hike is possible, though it could be confined to people in high income-tax brackets.
The bottom line is that no one knows what capital gains rates will be in the future, though they have generally been kept lower than income-tax rates in recent decades.