A Roth IRA Conversion Might Make Sense with Tax Increases on the Horizon

Both traditional individual retirement accounts (IRAs) and Roth IRAs are tax advantaged accounts.

With a traditional IRA, contributions to the account are tax deductible.  Appropriate distributions from the account are taxed in the future at income tax rates that apply to the account owner's future level of income.

Contributions to a Roth IRA are not tax deductible, but the future distributions are tax free.

Owners of a traditional IRA are able to convert their existing accounts to a Roth IRA, but they do have to pay regular income taxes on the amount of funds that are converted. 

The question that traditional IRA owners should be asking themselves is whether it is wise to convert and pay income taxes now, or simply wait and deal with whatever tax rates exist in the future.

Future tax increases seem likely in light of government stimulus programs and deficit spending.  In addition, the Obama administration has explicitly stated their desire to raise tax rates on higher income earners.

Consider the following highly simplified example:

1. Joe owns a traditional IRA that currently has $100,000 in assets.
2. Joe’s current marginal tax rate is 30%, while his marginal tax rate 5 years from now will be 40%.
3. Joe has a 5 year time frame, after which he wants to take an annual distribution from the IRA that equates to (again, a highly simplified example) 7% of the account value.
4. Scenario A: Let’s assume that Joe sticks with his traditional IRA and, again, the value of the IRA is $100,000.  Assume that Joe’s average annual return on that $100,000 over the course of 5 years is 7%.  Assuming no additional contributions, that would leave Joe with $140,255 after 5 years, at which point he would be able to take $9,817 from the IRA (his desired 7% withdrawal multiplied by $140,255).  However, his marginal tax rate in 5 years is 40% so the net amount of his distribution is actually $5,890.     
5. Scenario B: Let’s assume that Joe converts from a traditional IRA to a Roth IRA this year.  He pays $30,000 in income taxes and is left with $70,000.  Assume that Joe’s average annual return over the course of 5 years is 7%.  That would leave Joe with $98,178 after 5 years, at which point he would be able to take $6,872 from the Roth IRA (his desired 7% withdrawal multiplied by $98,178).     

The two scenarios are highly simplified, but the fact is that it makes sense for IRA owners to think about the impact of tax increases on future distributions and on their retirement planning in general.

Reference Source: Chicago Tribune