The wisdom of doing a Roth conversion depends in part on the rate of tax you would eventually pay on withdrawals from your retirement account if you don’t convert — your anticipated tax rate on withdrawals, or ATRW. In my first piece on ATRW I explained why you need to compare the highest rate you’ll pay in retirement with the lowest rate that will apply to the conversion. My second piece on ATRW looked at variables in your tax situation during retirement that may cause you to pay a higher rate than you anticipate. Now let’s look at another issue, the possibility of changes in the tax law that may result in higher or lower tax rates in the future.
When I spoke on the subject of Roth conversions to a gathering of financial planners earlier this year, one of the questions at the end caught me off guard. Someone wanted to know if it would make sense, in evaluating a Roth conversion, to take into account the long-term trend toward lower tax rates. When I repeated the question into the microphone for the other attendees to hear, there was actually some snickering from the audience. We all know tax rates are going up, not down, right?
The guy may have had a point, though. Most people considering a Roth conversion aren’t concerned about what the tax rates are going to be in the next few years. The important question is the tax rates that will apply during a retirement that may be many years in the future and could extend 20 years or more. If you look back over the last three decades, the overall trend in tax rates is downward. This is part of the legacy of Ronald Reagan. When he took office, the highest individual income tax rate was 70%, a number that’s unthinkable now in either of the major parties. By the time George W. Bush took office 20 years later, the top rate of 39.6% seemed high, and Bush expressed disappointment that he could reduce it only as far as 35%.
Yet I suspect the questioner was seeing the issue through a prism of his own political views. We have a tendency to think the general population will come around to the views that seem so sensible to us, and elect politicians who will put them into action. It’s hard to imagine that there are people who believe just as strongly in contrary views, and patiently wait for the public at large to see things the way they do.
We have some objective facts before us. They include huge budget deficits stretching decades into the future, creating enormous pressure for increased tax revenue. They also include an economy in which the income tax is woven into the long-term decisions of businesses and individuals, making it difficult to imagine the upheaval that would accompany a move to a different system of taxation altogether. In short, while we can’t entirely exclude the possibility that income tax rates will be lower in the future, there are powerful reasons to doubt that we’re on a continuing path leading inexorably in that direction.
Some people dismiss the idea of a Roth conversion on principle, saying it involves the certainty of paying tax now in exchange for uncertain tax savings in the future. Yet that’s the fundamental nature of every investment decision: we place money at risk in the hope that we’ll end up with more. Automatically rejecting a strategy that can produce great tax savings in the long run because it means paying more in the short run isn’t a rational approach to investing.
Tags: feature, Roth conversion
