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2010 brought a landmark opportunity to high-income investors. But surprisingly few people have taken advantage of it. Was all the attention garnered by the new Roth IRA conversion rules nothing but hype?
An open door to nowhere
For more than a decade, rich investors were locked out of Roth IRAs. Income limitations that kick in for singles with taxable income greater than $105,000 a year, and joint filers making more than $167,000, prevented high-income taxpayers from making contributions to Roths. A uniform $100,000 limit on conversions stopped them from doing an end run around contribution limits by taking existing 401(k) and IRA accounts and converting them into Roths.
But when 2010 opened, it ushered in a new era for Roth conversions. The income limitations disappeared, and suddenly anyone could convert existing IRA assets to Roths. The only problem? Nobody seems to be doing it.
New evidence shows that despite a big push from brokers and other financial institutions promoting the Roth conversion rules, only 14% of investors surveyed are even considering making the move. More than half of those surveyed said they definitely would not convert their existing retirement accounts to a Roth IRA.
So much for hype
Why aren't people converting? It all comes down to taxes.
It's true that converting to a Roth makes all your future returns on that money tax-free. But investors with traditional IRAs and 401(k)s already have some of the most important tax advantages that retirement accounts offer. In particular:
- Regular IRAs offer tax deferral. Even though you'll eventually pay tax on withdrawals, you don't have to pay taxes as long as your money stays in your account. So for instance, as European stock markets have swooned, shares of many European bank and telecom stocks have seen their trailing dividend yields rise to extremely attractive levels. Yet if you see those stocks as values rather than value traps at their current discount prices, you don't need a Roth to avoid paying taxes on their dividends as they come in; a regular IRA is sufficient.
- Similarly, you don't have to worry about capital gains taxes in an IRA. So the timing of exactly when you choose to lock in a big gain on high-flying stocks is completely up to you.
Perhaps more importantly, it's hard for many people to imagine a situation in which they'd end up winning with a Roth conversion. To convert, you commit now to paying income tax on the converted amount within the next few years. But you won't know until you retire whether it was really a good idea, because only then will you know for certain what your future tax bracket turns out to be.
In addition to the challenges of coming up with money to pay the tax, the income generated by a Roth conversion has some important ramifications for your current financial situation. Raising your income may affect your eligibility for certain benefits, including financial aid if you have children in college. Other tax benefits, such as the child tax credit, are dependent on adjusted gross income levels -- a figure that increases when you make a Roth conversion.
Moreover, you can't even be certain about the effect a conversion will have on your current tax bill. If you elect to spread out the taxable income resulting from your conversion over 2011 and 2012, you might well face higher tax brackets in those years than you do in 2010. In addition, you could end up getting snared by the provisions of the 3.8% Medicare surtax if a conversion raises your taxable income above the $200,000 to $250,000 threshold amounts.
Finally, those who have to pay state income tax will have to add the liability resulting from the conversion to their state tax bills as well. If your state doesn't recognize the federal option to spread out income over 2011 and 2012, you'll instead have to include all your income on your tax return for 2010. Some may even impose penalties.
After all this, you might conclude that converting to a Roth would never make sense. But that's too simplistic a conclusion to draw.
With some stocks, the potential of totally tax-free gains is too valuable to miss out on. Visa (NYSE: V ) and MasterCard (NYSE: MA ) , for instance, have suffered huge losses in light of possible new regulation on debit card interchange fees. Yet regulation could encourage more card use, which could help Visa and MasterCard grow, despite fee limits, and give shareholders long-term gains.
Similarly, BP (NYSE: BP ) , Halliburton (NYSE: HAL ) , and Transocean (NYSE: RIG ) have seen shares plummet because of the Gulf oil spill. But even though increased regulation could crimp short-term profits, the overall demand story for energy remains largely unchanged -- suggesting that these stocks could recover in the longer term.
If those ideas look appealing, then a Roth would maximize your after-tax profits from a recovery in those stocks. And even if they didn't work out like you hoped, you could recharacterize your conversion and avoid having to pay tax on money you lost -- essentially getting a do-over.
Even with those incentives, though, the complex nature of Roth conversions may stop people from taking advantage of them. It's crystal clear that investors are reluctant to pay taxes any sooner than they absolutely have to.