Roth IRAs behave similarly in their tax deferral aspect, but the mechanism for tax savings is opposite to that of a regular IRA. With Roth IRAs you get no income tax deduction when you put money into your account, but when the money comes out (again, after age 59 ½) no tax would be due. So the decision of whether to prefer individual IRAs or Roth IRAs, usually comes down to one's current income tax bracket now compared to what he or she expects to see when
retiring. For example, if I'm in a 25% tax bracket now, but expect to be in a 15% tax bracket when I retire, I would lean toward investing in a regular IRA (or 401(k) or 403(b), which works similar to a regular IRA), compared to a Roth IRA. If I can get a 25% tax deduction now, and pay just a 15% tax when I retire, that seems like a pretty good deal.
Conversely, if I'm currently paying 15% taxes, but think I might be paying 25% on my income when I retire, I would be inclined to lean toward the Roth IRA. In that case, I wouldn't get any current tax deduction, but would completely avoid taxes on my investment earnings over the coming years. Of course, there are other factors to consider, such as years until retirement, expected earnings, etc., but this basic example is the typical starting point for such a Roth IRA-Regular IRA analysis.
The many people who have a regular IRA and currently pay a low tax rate may conclude that since they expect tax rates to be higher in the future (probably a pretty safe bet), will be inclined to convert their regular IRA to a Roth IRA. Millions already have. However, up until this year, upper income taxpayers, those with incomes over $100,000, have been unable to convert their regular IRAs to Roth IRAs. That income limit is removed for 2010 and millions of upper income taxpayers are considering making the regular IRA to Roth IRA conversion.
Now, everyone's financial and personal situation is unique and personal finance decisions properly reflect unique circumstances. However, when it comes to tax planning, the planning aspect can only take you so far. The problem with doing such tax planning scenarios is that they involve current tax law, not tax laws one, two, or three decades in the future. From decade to decade, even year to year, we typically see big changes in tax laws, tax rates, tax rules, etc. In this case, although we may be able to predict that tax rates will generally be higher in the coming decades due to increased government spending, we can't accurately predict what will be taxed and how. In the case of the Roth IRA, we don't actually know what the tax laws regarding it will be in the years to come. For instance, because of government debt, the government may decide to tax the Roth IRA upon withdrawal during retirement, fully or partially.
This would not be unexpected. In recent history similar tax law changes have occurred, and these have been under times where there has not been severe financial distress in the government which will be occurring in coming years. For example, Social Security benefits were originally promised to be tax free for recipients. Now, many modest income retirees, can expect to see part or all of their Social Security benefits taxed. By the way, the same can be said for Social Security benefits themselves. In the past you could make as much other income as you desired during retirement and you would get the full Social Security benefits you were promised. That's not the case now. If you make "too much" earned income during retirement, at surprisingly low levels, your Social Security benefits are reduced. So you can easily see lower benefits than promised and higher taxes on those earnings. Similarly, in the 1980s, the tax laws were radically changed, negatively affecting taxability of certain "tax shelter" investments. There have been many other "bait and switch" changes within the tax system in past decades. Again, given that our government will be even more desperate for revenues in the coming decades, it seems likely that such tax law tricks will become more prevalent. If one converts a $100,000 IRA to a Roth IRA, pays 35% taxes on it, but discovers fifteen or twenty years later that he will have to pay another 35% on the proceeds, hindsight will have shown it to have not been the best move to make.
So taking this back to the Roth IRA, I don't want to dissuade people from investing in or converting to Roth IRAs. I have been a proponent of them for years and I invest in one myself. The decision to convert or not, or even to invest in a Roth IRA, is an individual decision that should be made with careful analysis, and preferably, an unbiased advisor. However, I believe the uncertainties underscore the need for diversification. We often talk about diversifying across various types of investments, countries, and economic sectors, but I think diversifying should extend across available investment vehicles.
As with choosing specific investments, one should not have all their investment vehicles in one basket, so to speak. These efforts are simply to guard against possible changes in the tax code that will occur in the coming years. As in any other area of life, if it seems too good to be true, it probably is. I'm not predicting doom for the Roth IRA, but I certainly would not be surprised to see
Roth IRA tax changes in coming years, probably negatively.
So again, to convert or not, or deciding what and how much to convert, is an individual decision, but it should not be a quick one. The government has extended the bait (conversion) in hopes of
hopes of getting immediate revenue, but IRA owners need to consider all the possibilities. Planning is fine, but you can only project what you know. The future is unknowable, and that is certainly the case when it comes to taxes.