Roth IRA Conversions-Part 3
This is the third article in a series dealing with the topic of converting your traditional IRA to a Roth IRA. This article will examine the impact of income tax rates. For other articles, see:
Part 1 – Reasons to Consider the Roth Conversion
Part 2 – The Recharacterization Option
Part 4 – How Long Can You Stretch?
Part 5 – The Impact of Investment Returns During the First 21 Months
Part 6 – The Impact of Estate Taxes
Part 7 – Ramifications of Charitable Giving
Part 8 - Putting It All Together
A comparison of the income tax rate that will apply at the time of the conversion and the income tax rates that would apply to future withdrawals from your traditional IRA is the most important factor in helping you decide whether or not to make the conversion. The general rule is easy to state. If you anticipate your future income tax rates to be lower, converting to a Roth IRA is likely to be a poor choice. If rates will be the same or higher, converting is likely to be a good idea.
Judging by historical standards, the current top marginal income tax rate in the U.S. is extremely low. Since 1932, there have only been five years (1988-1992) where the top rate was lower than it has been for the period of 2003 through 2009.
In light of the huge deficits that this country is facing, it seems inevitable that the highest marginal income tax rate will increase significantly. The top marginal income tax rate is currently scheduled to increase from 35% to 39.6% in 2011. The health care legislation that is currently being considered by Congress may include a surtax on the highest income taxpayers. We cannot tell for sure where rates are headed. However, there is a good chance that the highest rates will be increasing.
Not all wealthy individuals pay tax at the highest income tax rate. They may receive a lot of their income as tax-free interest on municipal bonds and tax-advantaged capital gains. Even if you are currently in the highest marginal income bracket, your income might decline in future years, especially if you are still working.
You need to keep in mind who will be paying the tax. It is reasonable for wealthy individuals to conclude that they and their spouses will always be in the highest marginal income tax bracket. However, if they only withdraw the required minimums, there will be a lot left in the IRA for their children. The children may not be in the top income tax bracket.
State income taxes should be considered. Tennessee does not impose an income tax on withdrawals from a traditional IRA. You might move to a state that imposes tax on distributions from a traditional IRA. It is more likely that your children will live in a state that imposes a tax on distributions from a traditional IRA.
You should also consider the possibility of leaving at least a portion of your traditional IRA to charity. If you are planning to make a bequest to charity upon your death, you should satisfy the bequest with a portion of your IRA. The income tax rate on distributions to charity from your IRA will be zero.
Even if income tax rates are highest in future years, this does not necessarily mean that you will benefit by converting. The conversion will likely force you into the highest bracket in 2010 because you will have the include the entire amount in your income for that year (or half in 2011 and half in 2012 if you make a deferral election).
The danger of higher income tax rates in the future will motivate a lot of people to convert at least a portion of their traditional IRA to a Roth IRA in 2010. Before you convert, you should consult with your CPA and other advisors to make sure that you are taking into account the myriad of factors that will determine the tax rates for you and your family if you do not make the conversion.