TAX NEWS - JUNE 2010

Be sure to make careful calculations before Roth IRA conversion

Q: I don't understand the hoopla related to the ability to convert conventional individual retirement accounts to Roth IRAs — even with the bonus of deferring taxes owed for the next few years. My tax rate will likely be lower in retirement due to lower income. (Even if federal taxes continue to be raised, I believe my reduction in income will at least keep the rate constant.) And if that assumption is incorrect, the future value of a dollar I would have to pay in taxes will undoubtedly be lower than the value of a dollar today. It seems to me this would more than make up for any tax increase we might reasonably expect.

So why would I want to pay taxes with 2010 dollars when I could pay them with future dollars? Based on an inflation rate of 3 percent, the value of $1,000 is going to be reduced to about $744 in 10 years. Am I missing something here? Unless you are going to retire very soon, this just does not seem to make sense to me.

R.G., Austin, Texas

A: Roth conversion definitely isn't for everyone, particularly those who expect to be in a lower tax bracket when they are making their retirement plan withdrawals. That's why you haven't seen much drum beating for conversion in this column.

Some people, however, face a nasty retirement surprise that may be avoided (under current, but ephemeral, tax law) by converting. If their IRA and other income trigger the taxation of Social Security benefits, they may not only need to pay taxes on their Social Security income, but their taxable income may rise from the 15 percent tax rate to the 25 percent tax rate. Since withdrawals from Roth IRA accounts are currently not included in the calculation of taxable income, Roth conversion may help some people avoid this unhappy event.

The operative word here is may. While it is possible to reduce income taxes substantially, it may not always put more spending money in your pocket.

You can understand this by taking an extreme case, a couple with $1 million in IRA assets and $40,000 in Social Security benefits. If they take $55,000 a year from their IRA each year, their cash income will be $95,000. About $29,400 of their Social Security income will become taxable, so their adjusted gross income will be about $84,400. Their federal income tax bill will be about $8,800. They will have $86,200 to spend — after income taxes.

If the same couple converts their IRA into a Roth and pays 33 percent in average taxes, they will have $670,000 left to earn income and all of it will be tax-free. At 5.5 percent, that would be $36,850, and none of their $40,000 Social Security income would become taxable. So they would pay $0 in income taxes. They cut their tax bill by a whopping $8,800. Unfortunately, they also cut their after-tax income from $86,200 down to $76,850 — so there was no benefit for them.

This kind of gambit is usually called "cutting off your nose to spite your face.'' And that's why no one should convert without making careful calculations first.