If you read any financial blogs or magazines, there’s no getting away from one topic. The Roth IRA, and the Roth conversion in particular. I continue to write about this because I think the choice isn’t always so clear cut. It’s rarely a “no-brainer” to convert and be certain it was the right decision.
I read and recently rediscovered an article in Kiplinger magazine titled “How to Finance a Roth Conversion.” Sorry, that title alone is enough to scare me. It implies a number of things. First, this couple in the article aren’t particularly liquid, they don’t have enough to pay the taxes on the conversion out of pocket. Second, they plan to convert so much that there will be a big tax bill. In fact, the amount they are considering converting is $250K, and it will result in a $100K tax bill, putting them into the 35% bracket. One planner advises that they proceed with the conversion splitting the income over two years on their tax return. This would make the first bill (say $50K) due in April 2012. He says they need to just save about $2K/mo from now until then, to pay this tax bill. He ignores the potential penalty and interest for underwithholding, and does a better job ignoring the next $50K bill that would be due only 12 months later.
Another planner thinks this couple should convert a bit at a time and pay [taxes] as they go. A more level-headed approach I’d say.
For this couple, the question of conversion is motivated by “higher taxes are coming.” Now, that may be, I really can’t say. One thing that does go in this couple’s favor is that they are both government employees. They are in a group that tends to have a better pension than most. Many public companies have discontinued their defined benefit plan, in some cases stopping further accrual, in others, cashing out their employees with a transfer to an IRA account. The question that remains for me regarding this couple, who are in their thirties and have an infant daughter – what do thing the chances are that you will both remain employed, full time, from now until the day you retire? Robert Burns’ To a Mouse contained the line “The best laid schemes o’ mice an’ men / Gang aft agley.” I wish this couple well, but a lower bracket between now and retirement isn’t necessarily due to a negative event. Maybe one of them wishes to stay home for a period after the birth of their next child. Maybe a new position becomes available in a state that has no income tax and they avoid the near 6% Virginia state tax. Time will tell, of course, this is just one example of those who are rushing into a decision I believe they’ll regret. Next week, I’ll offer an alternate approach that would save this couple quite a bit on their taxes.