Converting to a Roth? Not So Fast

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Despite declining federal budget deficits, the large and growing national debt has created a common perception that, at some point, tax burdens must rise to address the issue. While no one knows for certain, the mere belief that higher tax rates are inevitable has become a strong driver for advisors and clients to do whatever they can to manage that future tax exposure.

One of the most popular strategies has been to take tax exposure off the table altogether by contributing to Roth accounts and/or doing Roth conversions. The goal: Pay taxes now, when rates are lower, and not in the future when they may be higher.

Yet a closer look at tax reform paths that could address national debt suggests that while tax burdens may be higher in the aggregate at some point in the future, marginal tax rates will not necessarily be higher. In fact, most reform proposals, from the bipartisan Simpson-Bowles plan to the recent ideas of Rep. Dave Camp (R-Mich.), actually feature a widening of the tax base and an elimination of many deductions, accompanied by a lowering of the tax brackets.

Similarly, proposals to shore up Social Security and Medicare often involve simply raising the associated payroll taxes that fund them — increases that would raise the tax burden on workers, but not increase the taxation of future IRA withdrawals.

Meanwhile, the U.S. also remains one of the only countries that does not have a value-added tax — changing that would also be a way to increase the national tax burden without raising marginal income tax rates.


What does all of this mean? The simple reality is that there are many paths to higher tax burdens in the future that won’t necessarily raise marginal tax rates on IRA withdrawals. Which suggests that, ultimately, advisors should be very cautious about doing Roth conversions, especially at current rates of 33% or higher.

Instead, the best possible move with a pretax IRA may be to continue to hold it, and wait for tax reform that increases tax burdens but lowers marginal tax rates.

After all, when considering a prospective Roth conversion (or contribution), the basic principle for maximizing long-term wealth is relatively straightforward: Pay the taxes when the rate will be lowest. If a client’s tax rates are higher now and will likely be lower in the future, keep the pretax account, and wait and withdraw at those lower future rates. If the rates are lower now and will likely be higher down the road, convert or contribute to the Roth and pay the tax bill now.

The caveat to this approach, though, is that it’s crucial to understand what tax rates are being compared.

Because a Roth conversion (or a future traditional IRA distribution) happens at the margin — on top of whatever income and deductions the clients already have — it’s crucial to look at the marginal tax rate, now and what’s likely in the future.

Finding that marginal tax rate means looking at more than an individual’s tax bracket because income-based phaseouts of tax credits and deductions can make marginal tax rates far higher than the bracket suggests.


At the same time, it’s also important to recognize that a marginal tax rate is just that — a tax rate, at the margin, on the last dollar of income. It does not necessarily speak to a person’s total tax liability, or the overall share of their income being consumed by taxes each year. That’s measured by the effective tax rate.

For example: A married couple earns $350,000 of ordinary income and faces a marginal federal tax rate as high as 39.8%: a 33% tax bracket plus two percentage points for the phaseout of personal exemptions, one point for the phaseout of itemized deductions and a 3.8% Medicare surtax on net investment income.

Yet their actual tax liability is only $85,231, assuming two personal exemptions and $15,000 of itemized deductions, both partially phased out. On a $350,000 income, that is equivalent to a 24.4% effective tax rate.

While the couple may be adding income at the margin at almost 40%, their overall tax liability on the income already earned is not nearly that high. Nonetheless, adding a Roth conversion at that point would come at the marginal rate, regardless of what they had already paid on prior income.


Consider why the distinction between marginal and effective rates is so important, beyond simply helping advisors perform an accurate analysis in the first place.

As noted earlier, the growing demand for tax reform to resolve ongoing federal deficits means many clients (and advisors) are increasingly concerned about the risk that tax legislation may eventually increase their tax burden.

Yet an increased tax burden might only raise effective tax rates, and not marginal rates.

At a broad level, there are three fundamental levers that could generate more total tax revenue:

  • Expand the tax base by taxing more types of income, taxpayers, etc. This could change an individual’s effective tax rate, by including more income in the tax formula, but it doesn’t change the marginal rate.
  • Keep marginal tax rates but reduce deductions. This increases the effective tax rates, but there still isn’t necessarily any impact on the marginal tax rate. After all, the whole point of eliminating deductions is that it raises the burden on existing income, not the rate on the next new dollars of income. (For instance, if in the prior example we changed the law to limit deductions and it reduced the couple’s available deductions by $10,000, their tax liability would rise to $88,531 and their effective tax rate would be 25.3% — but their marginal tax rate would still be the same.) Higher effective rates and a greater tax liability don’t necessarily mean higher marginal tax rates. 
  • Increase marginal tax rates. This is the only lever that actually increases future marginal tax rates — and it hasn’t been a very popular idea.

The reality of major tax reform is that lawmakers most often rely on the first and second options to increase taxes, leaving the third untouched.
For instance, the Tax Reform Act of 1986 eliminated a significant number of tax preferences and deductions, expanded the types of income being taxed (by eliminating a lot of real estate and other tax shelters), and widened the tax base so that the top marginal tax rate fell to 28% by 1988 from 50% in 1986.

This 1986-style tax reform has also been advocated in recent years. For instance, the Simpson-Bowles proposal floated in 2010 would have eliminated most tax deductions and expanded ordinary income treatment to capital gains and dividends, but reduced the tax brackets to a simple three-bracket system, with rates of 9%, 15% and 24% (and a top rate possibly as high as 27% if some deductions were kept). The result would have been an increase in effective tax rates, but a dramatic decrease in marginal tax rates for many high-income taxpayers.

And the more recent Camp proposal would similarly limit itemized deductions, and reduce tax brackets to three (10%, 25% and a top 35% rate for married couples with more than $450,000 of income) — again reducing marginal tax rates, although by less than the Simpson-Bowles plan.

There’s another issue: To the extent that tax reform does increase marginal tax rates, such a change doesn’t necessarily impact everyone. While it is often noted that the top tax bracket was as high as 94% in the aftermath of World War II, the reality is that tax rate was rarely applied: It was subject to an incredibly high bracket threshold (it would have taken almost $2.5 million in today’s dollars to trigger that rate), as well as a very different structure of deductions and exemptions.

In addition, the reality is that some of our greatest drivers of projected future deficits stem from Social Security and Medicare. Both could be solved by increasing payroll taxes, raising the Social Security tax to 15.1% from 12.4% and the Medicare portion to 4.0% from 2.9%.

Both of these tax increases would have a significant economic impact, and would result in a higher tax burden for some — but they would not raise tax rates on future IRA withdrawals.

Similarly, if the U.S. were to add a VAT or national sales tax, the total tax burden on money spent at the cash register might be higher — but once again, it wouldn’t be an increase in income taxes.

The bottom line: Even if the total tax burden and effective tax rates must rise in the future, marginal income tax rates (especially on IRAs) may not end up higher at all.


What happens if clients do Roth conversions and it turns out that these various tax reform proposals come to pass as noted above?

Clients could end up paying taxes on their Roth at today’s higher rates when they could have waited and paid taxes on their IRA withdrawals at lower marginal rates in the future.

In other words, the clients will have actually destroyed long-term wealth by trying to dodge higher future tax burdens, not realizing that those future tax burdens could come with lower marginal rates.

As noted, this outcome is not far-fetched. In fact, most current scenarios and proposals — such as the implementation of a VAT, raising Social Security and Medicare taxes, or tax reform proposals that pair a widening of the tax base and a reduction in tax preferences and deductions, without raising tax brackets — are actually paths to lower marginal tax rates in the future.

Realistically, it’s worth noting that tax reform doesn’t seem very probable in the immediate future. Camp’s proposal didn’t advance in Congress, and the Simpson-Bowles plan has seen little movement since the report was released four years ago.

There may be no progress on tax reform until after the next presidential election, when we see whether either party takes the White House and enough of Congress to push through its version of reform. (Both parties largely agree on the general structure of reform; the debate centers on whether the net result should be revenue-neutral or a revenue raiser.)

It does seem likely that tax reform will come at some point, and there is a strong likelihood that it will involve a greater future tax burden. But it’s crucial to remember that a higher future tax burden does not necessarily mean higher marginal tax rates in the future.

For those clients who seek conversions out of a fear of future tax legislation, be very cautious about doing Roth conversions — especially in tax brackets of 33% or more. Most recent tax reform proposals have had a top rate no higher than 27% (or, at worst, 35%, but only at ultrahigh income

In the end, the best course of action for most IRA accounts may be to wait for tax reform to happen, and do the withdrawals (or Roth conversions) then — when the marginal rate may be lower.

Michael Kitces, CFP, is a Financial Planning contributing writer and a partner and director of research at Pinnacle Advisory Group in Columbia, Md. He’s also publisher of the planning industry blog Nerd’s Eye View. Follow him on Twitter at @MichaelKitces.

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