Doing the Roth Roll: The Quiet Explosion in IRA Conversions
Back in 2005, Congress gave many high-income savers a great gift, with the proviso that they couldn’t unwrap the package until this year. The bequest allowed the affluent to convert their traditional tax-deferred Individual Retirement Accounts into tax-free Roth IRAs. Now that these lucky investors have torn open the box, we’re beginning to learn what this opportunity will mean both for them and for federal revenues.
I asked the folks at financial services giants Vanguard and Fidelity how clients were responding. And they say there has been tremendous interest. At Vanguard, nearly 100,000 converted though May, five times the normal pace. And most were wealthier investors. Fidelity clients have converted four times more frequently this year than last. A Fidelity survey of tax advisers reported that more than 40 percent of roll-overs have been for accounts of $50,000+. And this may be the bow of the wave. Both firms expect a bigger spike in conversions once clients focus on tax planning later in the year.
This new interest in Roths is hardly a surprise. Until this year, only those earning less than $100,000 could convert a traditional IRA (or an inactive 401(k) from a former employer) to a Roth. Now, anyone can do the roll, regardless of income. The one catch: They must pay tax on the conversion as if it was a withdrawal.
Still, converting to a Roth has big benefits. Future earnings will be fully tax-exempt. This is especially valuable these days, when stock prices are still relatively cheap and account values are low. In contrast to ordinary IRAs, investors do not have to begin withdrawals at age 70½, so their tax-free savings can grow for longer. Not only can wealthy investors roll traditional IRAs into Roths, they may also be able to make future contributions to these tax-free accounts (although in an indirect and somewhat convoluted way). Finally, doing the Roth roll allows taxpayers to lock in today’s relatively low tax rates, especially if they think (as I do) that rates will surely rise.
The decision to convert is not clear-cut. You'll need cash to pay the upfront tax (if you use funds from inside your IRA, you’ll have less to put in the tax-free account and lose most of the benefit of the rollover). Moreover, since the converted account is treated by the IRS as income, the roll could throw you into a higher tax bracket. While the law allows those who convert in 2010 to spread their tax over 2011 and 2012, top rates will almost surely be higher following the expiration of the Bush tax cuts at the end of this year. Still, shifting to a Roth can be a great deal for some wealthy savers.
It is no bargain for the government, however. Congress adopted the tax change in part as a fiscal gimmick. That’s because, within the 10-year budget window (all that matters in
Still, the Siren Song of the Roth seems too much for government to resist. For instance, the Obama Administration will soon propose making Roths, rather than old-style tax-deferred IRAs, the default form of retirement saving.
This infatuation with all things Roth bears close watching. Last month, the Congressional Budget Office estimated that between 2010 and 2035, projected revenues would rise by 0.5 percent of GDP thanks to deferred taxes paid on defined benefit retirement plans. That's serious dough–about $75 billion in today's money. It’s great that Congress wants to encourage private savings. But giving wealthy investors a long-term tax windfall on money they have already put away is hardly the best way to accomplish this laudable goal.
I'm probably naive, but I just don't see the value. Unless you have a secret or are a savvy investor, the current investment yields don't justify the taxes you'll pay, not to mention the AMT, even without any Congressional intervention. The original purpose of the IRA was to defer taxes until retirement when you supposedly would be in a lower tax bracket. I don't see how that's changed.
Len, in one way, you are correct – a VAT would exist on its own, so whether you convert or not you will pay the same thing when you spend the money. From the point of view of someone who has converted and thinks that they have escaped future tax liability, suddenly having to pay a VAT would seem like a betrayal. The same is true for heirs, who think after they pay their estate tax (or have dodged it) that they are home free. A VAT makes sure they are treated like everyone else – which is a good argument for a VAT with a decline in income tax rates.
That depends on how high you set it and how low you set income tax rates. Under my plan, where income tax rates range from 4% at the 100K and above level for families (going up by 4% at $75K increments to a 28% rate over $550K) and a 30% expanded business income tax (a VAT with exclusions), a rebate would probably be necessary – although it might not amount to much for very wealthy taxpayers.
Michael, A VAT wouldn't affect the tax advantage of converting, except insofar as it led to lower income tax rates.
No, the Machiavellian move would be to enact a Value Added Tax, so that the funds that were converted are taxed a second time (the higher rate the better) without offering a rebate to those who pre-paid.
If the Gov't was truly Machiavellian, they would let all the Roth conversions go through – as they are currently – and then impose a recapture rule similar to the current rule for the taxation of social security benefits where benefits up to total income of $X are not subject to tax but benefits above $X are taxable. Since most of the Roth conversions are being done by high income folks who will have high income in retirement, if total income is in excess of $Y then Roth contributions are subject to an additional tax.
Further, this proposal could be used to justify relaxing the 10 year budget window score keeping rule that Congress currently uses to help address the long term budget situation since most Roth account dollars will not be withdrawn during the next 10 years, but will be withdrawn during the next 30 years. This could be done to address part of the “structural” deficit that we confront due to an aging society.
This is the most odious of stupid tax tricks. It targets those who don't need savings for retirement. Besides for the tax advantages Howard mentioned, it also is a great estate tax dodge since prepaying the tax reduces the size of taxable estate. (Traditional IRAS are subject to income and estate tax.) Again, this only benefits the uber-rich.
The one silver lining for someone who hates this policy (like me) is that many people who engage in the rollovers will discover that they're subject to a whopping AMT hit on the rollover. If the AMT is eventually eliminated, some upper middle income people who do rollovers may find their retirement income taxed at a significantly lower rate than their rollovers. Of course, I'm just guessing about future policy, but the AMT could increase effective rates by 6.5 or 7 percent for rollovers above statutory rates. It largely leaves the very rich unscathed (since they don't pay AMT), but not the moderately well off.