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It is more often that you hear or read of reasons to convert from a Traditional IRA to a Roth IRA than you hear or read of reasons not to convert. Given the fact that this column pertains to the latter, we will only briefly note the reasons to convert. These include the potential for rising personal income tax rates, tax free withdrawals after five years from a Roth and no mandatory distributions. That said, there are several reasons why one should not convert from a Traditional to a Roth IRA.
First and foremost, a bird in the hand is worth two in the bush. When you convert from a Traditional to a Roth IRA, you must pay the tax on the conversion immediately. This has two negative consequences, the first being that you are paying those taxes from retirement savings thereby reducing those savings and secondly that the tax money is now in the pocket of the Internal Revenue Service rather than continuing to work for you.
One must also keep in mind that the dollar amount that is converted is added to your current income and taxed as ordinary income, which for most of us is at a federal rate of 28%. This added income may push you into a higher tax bracket or cause your Social Security Benefits to become taxable, if you are currently collecting.
Another reason not to convert is that for many of us, our tax bracket during retirement may be lower than our tax bracket while working. If you convert during your higher income earning years, you will most likely lose 28% to the IRS. However, there is a fair chance that in retirement you may be in a lower tax bracket, perhaps 15%. Therefore, why pay 28% now when you can pay 15% later?
Current law states that an individual may begin to withdraw from your Traditional IRA without penalty after you turn age 59½, but that you must begin to make withdrawals on or before April 15 following the year the individual turns 70½. For some of our clients, we are able to make calculated withdrawals between these dates in such an amount that will keep the client in a low tax bracket. This is another reason not to convert while you are in a high income tax bracket.
We like to turn the tables on those that recommend conversion due to the fact that with Federal and State budget deficits at alarmingly high levels, higher personal income tax rates are a fait accompli. Although we do believe that marginal rates will rise, we do not consider it a done deal nor do we believe that they will rise substantially for the middle class.
With the tidal wave of baby boomers set to retire and thus set to begin to live on their savings, pensions and Social Security, we believe the Federal Government through the IRS will begin to explore different methods of taxation as a supplement to the personal income tax. These alternatives include a flat tax, a value added tax (VAT), consumption tax or a national sales tax. This may result in personal income tax rates remaining at or near where they are now with the added revenue coming one or more of these four sources noted immediately above.
Finally, although somewhat remote and given the wave of baby boomers nearing retirement, we would not be surprised should the government eventually tax distributions from Roth IRAs should the income or assets of the taxpayer exceed a certain level, a la Social Security. “Somewhat” remote, but not that unlikely. Think about it.
THE BOTTOM LINE – Think twice prior to converting from a Traditional to a Roth IRA. As noted above, a bird in the hand is worth two in the bush. Why pay taxes now when you can pay them later.