Tax Brackets Key to Roth Conversions

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Deciding whether to convert a traditional IRA into a Roth is a tricky decision involving a little math and a lot of guesswork. Many people are wrestling with the problem this spring, as new rules allow anyone to convert to a Roth, not just those earning less than $100,000 a year.

The Roth allows tax-free withdrawals in retirement, while you must pay income tax on withdrawals from traditional IRAs, or TIRAs. But income tax is levied on sums converted from TIRAs to Roths. So, the question is whether to pay tax now or later.

Many factors affect the math — the expected rate of return on investments, inflation, the number of years to retirement and so forth. But one is clearly the most important — how your tax bracket may change over time.

If you know the numbers, the Roth IRA Conversion Calculator can make the pros and cons of a conversion very clear. Unfortunately, no one can predict future tax brackets with any certainty, as that will be determined by your income and tax laws (which have a habit of changing dramatically from decade to decade).

Let’s start with a simple example using the calculator’s default figures. A 28-year-old planning to retire at 65 has $10,000 in a TIRA and expects returns to average 8% a year. In the bar graph, the key is to compare the nest egg that could be built up in the Roth with one you could have by keeping the TIRA and also investing the money you would save by avoiding a conversion tax. (A full explanation of that will come in the next column.)

The graph shows that keeping the traditional IRA makes the most sense. That strategy will produce $175,000, while converting to a Roth will produce $172,000.

This assumes the investor is in a 25% income-tax bracket now but will face a 15% bracket in retirement.

What if you reverse those figures, assuming a 15% bracket now and 25% in retirement? Then the Roth conversion would clearly make sense, producing $172,000 versus $146,000 with the traditional-plus-taxable strategy.

In a nutshell, converting means paying tax today to avoid tax later. It makes sense if the future tax rate will be higher than today’s. It doesn’t if the future tax rate will be lower.

Obviously, the trick is to figure what your future tax bracket will be. No one knows what the tax brackets will be 10, 20, 30 or 40 years from now. Currently, it seems more likely that tax rates will rise than fall, as the government wrestles down its enormous budget deficits and accumulated debt.

So, it seems prudent to assume that if your income will be higher in retirement than today, your tax rate will be higher as well.

Of course, most people assume the opposite — that their incomes will fall in retirement. That would shift you into a lower tax bracket, unless the government raises tax rates.

The best approach is to try a variety of scenarios in the calculator. You’ll quickly see that changing the tax assumptions has dramatic effects on the relative merits of each approach. Factors like the investor’s age and investment return have much less impact on the conversion decision, though they do change the final values of each investment option.

If your situation makes the decision a toss-up, consider converting just part of your TIRA holdings to give yourself more options in retirement. In years when your income and tax rate are high, you could withdraw from the tax-free Roth, and when your income and rate are low you could use the TIRA, allowing the Roth another year of tax-free growth.

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