A recent article in the BNA Pension Reporter analyzed the complex issues of converting IRAs to Roth IRAs in 2010. The authors acknowledge that paying taxes early is counter-intuitive but conclude that conversions in 2010 make sense for taxpayers who are in upper middle incomes and above if income tax rates are increased substantially in the future. If income tax rates are not increased substantially, then the conversion makes sense only for taxpayers with extraordinary circumstances.
The tax law allows all taxpayers to convert their conventional IRAs to Roth IRAs this year and spread the additional tax liability over 2010 and 2011. A taxpayer can make the conversion in 2010, but revoke it any time up until the time the return is filed for 2010. The advantages of conversion are that the future income generated by the Roth IRA account will not be subject to taxes and there will not be any minimum required distributions from the Roth accounts. The usual Roth limitations apply so that the tax advantages disappear if the taxpayer withdraws the funds prior to age 59-1/2 or within five years after the conversion.
The authors make the case that federal taxes are going to have to increase because of our current deficit and the unfunded entitlements in our federal system. The increase may be in the income tax structure or we could have a federal sales or value added tax or both. If the increases come in the form of a value added or sales tax, the potential advantages of a Roth conversion do not materialize.
The authors also acknowledge that the current rules concerning the taxability of Roth IRAs may be changed in the future. If that happens, then the advantages of conversion may be diminished. Examples of changing tax rules can be found in the history of the taxation of social security benefits and the Medicare Part B premiums. Social security benefits were not subject to federal income tax for many years, but that was changed and a portion of social security benefits are subject to federal income taxes. Initially, Medicare Part B premiums were the same for everyone, but now higher income taxpayers pay a larger Part B premium. Whether changes will be made with respect to Roth IRAs in the future is everyone’s guess.
The article suggests that upper income taxpayers may want to hedge their bets and convert a portion of their IRAs to Roth this year. This will allow them to do some additional tax planning in the future and withdraw from their traditional IRAs in years of lower income or higher deductions, and withdraw from the Roth IRA in years of higher income and lower deductions.
The article concludes by saying that “a Roth conversion is essentially a gamble based on future unknowns.” And as Yogi Berra might have said, “Predictions are hard to make, especially about things that may happen in the future.”