For many investors, deciding whether to convert to a Roth IRA hinges on a bet about future income-tax rates. But there’s another tax question that can slip by unnoticed: Will capital gains rates go up or down?
Conversion is most likely to pay if you assume your income tax bracket will be higher in retirement than when you convert. Although you would have to pay tax on the converted amount, you’d avoid a higher tax rate on withdrawals if you kept the traditional IRA. Roth withdrawals are tax-free.
The BankingMyWay.com Roth IRA Conversion Calculator shows three possible outcomes. First is the future size of your nest egg if you convert. Then is the projected size of your traditional IRA. Both calculations assume all taxes are paid.
The third calculation shows what your account could grow to if you stuck with the traditional IRA and also invested the money you save on current taxes by forgoing a conversion.
Since this money would be invested in an ordinary taxable account, it would be taxed. If it were invested in assets such as stocks or stock funds that produce most of their returns from long-term capital gains, profits would be taxed at no more than the long-term capital gains rate of 15%. Withdrawals from the traditional IRA would be taxed as income, currently at rates from 15% to 35% for most investors.
But what if the capital gains rate changes? Over the past two decades, the maximum rate has fallen from 33% to 28% to 20% to today’s 15%. The most recent cut is scheduled to expire at the end of 2010, restoring the 20% rate, but Washington could change that. Given the big federal budget deficits, a rate hike is possible, though it could be confined to people in high income-tax brackets.
The bottom line is that no one knows what capital gains rates will be in the future, though they have generally been kept lower than income-tax rates in recent decades.
In the calculator, the long-term capital gains rate is entered in the “investment tax rate” window, where the default value is 15%. Keeping all the default values, the most profitable option is to keep the traditional IRA and invest the tax savings.
But if the investment tax rate is raised to 20%, the Roth IRA edges in front. Lifting the investment rate to 28% makes the Roth conversion the clear winner.
But the results change if you experiment with the other factors. In many cases, the best option is to keep the traditional IRA and invest the tax savings, but this option’s edge gets narrower as you raise the long-term capital gains rate.
In most cases, the Roth conversion will pay off if you assume your income tax rate will be higher in retirement. But assumptions about the capital gains rate can tip the balance in a close call.
The best approach is to try a lot of combinations of investment returns, retirement age and tax rates to get a sense of the best and worst possibilities.
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