At the beginning of 2010, an amazing investment opportunity opened to everyone. Yet many investors haven't yet budged toward taking advantage of it -- and a majority of them seem determined not to do it at all.
Mutual fund company Putnam Investments recently surveyed around 1,000 retirement savers to ask them if they planned to take advantage of a new rule allowing anyone to convert an existing retirement account to a Roth IRA. Despite the potential benefits of converting, over half said they had no plans to do so, citing uncertainty about whether the move would ultimately do them any good.
The Roth grand opening
Roth IRAs have been around since 1998, giving retirement savers a second weapon in their tax-favored account arsenal. Traditional IRAs and 401(k) plan accounts allow savers to deduct or exclude income from their current-year tax returns, giving them immediate savings and tax deferral throughout their careers. Once you retire, however, it's time to pay the piper -- whenever you take money out of your account, you'll have to include it as taxable income.
The emergence of the Roth gave investors another option. Instead of getting a tax break now, you could forego a deduction and instead get tax-free growth for the life of your account -- even when you take money out after you retire.
Roths, however, have been off-limits to high-income taxpayers. Until this year, if you earned too much, then you could neither contribute to a Roth nor convert an existing traditional IRA to a Roth. But this year, a portion of those restrictions were lifted. Now, anyone can convert to a Roth.
The sound of silence
But so far, response has been muted. T. Rowe Price told Bloomberg that it has seen only a "very small fraction" of its accounts convert. Fidelity saw conversions quadruple, but only to 58,000 -- likely not a huge number, given Fidelity's huge size overall.
So with the doors wide open, why aren't people converting? The key is that to convert, you have to commit to paying tax -- by including income either on this year's tax return or split evenly between your 2011 and 2012 returns. But there's all sorts of uncertainty about whether that's a smart move:
- The conversion decision hinges on whether you believe your current tax rate is higher or lower than what you'll pay when you retire. But with tax laws up in the air, it's impossible to guess what your future tax rate may be.
- Many are concerned that future tax laws may impose new retroactively applied taxes on Roths. They point to Social Security retirement benefits, which used to be tax-free but are now included in income for some taxpayers. Also, the government is using similar retroactive threats against Berkshire Hathaway
(NYSE: BRK-A) (NYSE: BRK-B), with legislation that would force it and other companies to reserve against its derivative exposure the same way as top derivatives players JPMorgan Chase (NYSE: JPM), Goldman Sachs (NYSE: GS), and Bank of America (NYSE: BAC)-- even on contracts that they wrote years ago.
- Similarly, changes in the structure of taxation could also render Roths moot. For instance, proposals for a value-added or consumption tax would force people to pay tax on what they spent, even if that money came from their Roths.
In fact, it's tempting for many to conclude that they're almost certain to earn less in retirement and therefore be in a lower tax bracket. But there are some flaws to that reasoning.
First, there are many moving pieces to your taxes after you retire. For instance, Roth withdrawals don't impact how much of your Social Security benefits get taxed, but regular IRA withdrawals do. That's something that doesn't appear in the tax rate tables, but it can cost you more come April.
There are also longer-term issues that play a role. You never have to take money out of your Roth IRA and can pass it untouched to your heirs if you like. They in turn can take it out in small pieces over the course of their lifetimes. Traditional IRAs, however, require you to take withdrawals after you turn 70 1/2, which reduces your ability to leave your retirement money to your heirs.
Take a closer look
Perhaps the biggest hesitation comes from the fact that stocks have rebounded so strongly. No one wants to convert and lock in tax on an amount that could disappear tomorrow. Even though the ability to recharacterize a Roth conversion later makes that less of a concern, it's a complicated provision that many probably don't understand.
It's true that converting doesn't make sense for everyone. But many who would potentially benefit are missing out. Unfortunately, it's all too likely that many will look back on their decisions not to convert as a lost opportunity.
Regardless of whether you have a Roth, you need to invest well. Fool retirement expert Robert Brokamp explains why stocks shall rise again.
Fool contributor Dan Caplinger respects his Roth. He and the Fool both own shares of Berkshire Hathaway, which is a Motley Fool Inside Value recommendation and a Motley Fool Stock Advisor selection. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy gets all the respect it deserves.