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To convert or not to convert

To convert or not to convert

Scott Maxwell - Thursday, August 28, 2014

A popular and sensible strategy that folks use to minimize their tax burden over a lifetime is the Roth conversion. Many of you realize that IRA's come in two flavors, traditional and Roth. The traditional IRA allows one to invest up to 6,500 per year (in 2014, these limits are adjusted over time) and get a tax deduction for their contribution. The Roth has very similar contribution limits but allows for no current tax deduction. Instead, the earnings in a Roth are tax-deferred and under the right circumstances those earnings can be withdrawn tax free! There are lots and lots of rules about the tax deductibility of traditional IRA contributions and the conditions needed to obtain tax free withdrawals from a Roth, our purpose here today isn't to cover those but rather to think a bit about Roth conversions.

A conversion is an "extra provision" in regards to Roth IRA's that allows one to "convert" their Traditional IRA (or some portion thereof) to a Roth IRA. When the conversion occurs the IRA owner pays taxes on the amount converted and thereafter those funds (under the right conditions) grow tax-free in the Roth. Why would one consider a Roth conversion? If future tax rates for that individual are likely to be higher than current rates than a conversion could make sense; pay taxes at the current lower rate and avoid paying them in the future when actual rates or their own tax rate is lower.

This same line of reasoning holds true when considering what sort of IRA to contribute to of course. The simple rule is that if your tax rate is likely to be different between the time of the contribution and the expected time of withdrawal than one engineers the contribution or conversion to favor the lowest expected rate. Earning a lot now and in a high bracket? Conversion makes no sense and contributions should be to a traditional (tax deductible) IRA. Just the opposite? You get the idea.

Care should be taken when thinking about conversions. One can be tempted to assume that marginal tax rates will be higher in the future than they are now. What with large deficits and an ageing population, deteriorating infrastructure and the size of our debt it's a cinch that tax rates have to higher in the future right? Well, maybe not. It may be that the tax rates on income will be pushed higher but there is an awful lot of resistance to this idea. It may instead come to pass that we find other ways to raise revenue without increasing the rate that we pay on ordinary income. We might adopt a VAT (value added tax) or we may fund infrastructure through user fees and other tax mechanisms.

If the disparity between your tax bracket now and your expected bracket in the future is significant, based on today's tax rates on income, than a Roth conversion or the choice of which IRA to contribute to may be a no-brainer. But if you are counting on rates being higher in the future than they are now and making that a cornerstone of your strategy than you may want to at least consider the idea that higher future levels of taxation may not come from an increase to income tax rates but instead may derive from some new entirely unexpected sort of tax that won't be triggered when you withdraw from your IRA.

IRA conversions are tricky things and it's worth taking a long hard look, (and getting some advice) before undertaking a conversion strategy or making big choices in regards to the destination of your contributions.

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