Roth Conversion…or not?

A hot topic this year with clients is the discussion of whether or not to take advantage of the 2010-2011 Roth conversion option.   From our perspective, in comparison to most in the industry, it may not be such a great idea.

You hear much about the conversion process and benefits, and many who promote the conversion tend to have some amount of financial benefit for performing the conversion for you.   As the client, you pay the tax bill and move on.   But is it such a great idea?

From our perspective we aren’t as comfortable in the idea for the majority of our clients.   First, we believe this is more of a gimmick to generate tax revenue in a sluggish economy by tempting presumably working (and higher tax bracket individuals) to convert their traditional IRA’s to Roth accounts.   If you think about it, why is there sudden apparent “good will” from the IRS towards taxpayers?   Why would the IRS be so inclined to offer this benefit if there wasn’t some motive behind it?

We believe that because most individuals who have substantial IRA accounts are 1) employed and 2) likely in a higher tax bracket, which 3) would push them into the highest tax bracket when the conversion is taken.   And remember, its not just the conversion funds that are now taxed at the higher (or highest) ordinary income tax bracket, it’s all of the regular income (wages) that are subject to taxation at that now higher tax bracket for the year.

We feel that its best to keep your traditional IRA’s in place and continue to invest tax deferred.   There is great certainty that when you do begin to take distributions from your IRA you will be 1) retired, 2) in the lowest tax bracket and 3) not likely to push yourself into a higher tax bracket when distributions are taken.   Moreover, we have no idea what the tax system may look like at the time of your retirement but there is a good chance it might look very different (even positive) from today’s existing tax structure.  At the very least at the time of retirement you should be in the lowest tax bracket, trickling out distributions (compared to a large lump sum today at the highest taxable bracket) and continuing to compound tax free within your IRA.