Wealthy taxpayers are scrambling to figure out what they can do now to soften the blow of higher tax rates in the future. They would be wise to hold off on one tactic that's getting a lot of buzz: Converting savings in a traditional individual retirement account to a Roth IRA.
With a traditional IRA, those planning for retirement are eligible for tax deductions for their contributions, but then have to pay income taxes on their withdrawals. Roth savers pay taxes upfront but not on withdrawals.
That makes Roths attractive to people who think they will be in a higher tax bracket in retirement, because any investment earnings taken out aren't considered income for tax purposes, as long as the account has been held for five years and the accountholder is at least 59½ years old.
President Joe Biden has proposed increasing the top income tax rate to 39.6% from 37% for single tax filers earning around $450,000 and married filers earning about $500,000. But taxpayers, especially those near the cutoffs, need to keep in mind that it's just a proposal. Rates may increase in the future, but how high and for whom is still a long way from being decided.
Rushing to convert an IRA to a Roth now could backfire for those who incorrectly assume they'll be subject to higher rates. And if the Biden plan does move forward, switching can typically be completed in a day or so with the click of a few buttons.
Also, since we're almost six months into this year, it's reasonable to expect any tax changes to take effect in 2022.
Another thing to keep in mind is that tax policy is revised all the time under different administrations. So even if changes were to happen in line with what Biden is proposing, it's a big gamble to assume those tax hikes for the wealthy would remain in place for long.
Switching also comes with opportunity costs. Money used to pay the Roth taxes upfront could be used to invest elsewhere with potentially generous returns. Plus, who knows if down the road that money you used to pay those taxes will be needed for something like long-term care.
Those considering a conversion should also remember that it's irreversible thanks to the 2017 Republican tax law. Before that, savers were given a reprieve and could convert to a Roth IRA and then switch back to a traditional IRA if they changed their minds. Not so much anymore—a single year's contribution may be re-categorized, but not the whole thing.
Those intent on converting to a Roth could benefit by doing so a little at a time, moving part of a traditional IRA each year. They should keep an eye on income thresholds, though, to avoid transfers that move them into higher tax brackets.
Other things to think about: What funds are available to pay the upfront taxes? How many years until withdrawal starts? There are different income thresholds, not just for ordinary income tax rates, but for other taxes too, like the 3.8% Medicare tax (which kicks in at $200,000 for single filers and $250,000 for joint taxpayers). Also, there are income limits for contributing to a Roth, but no limits for converting.
Savers who are most concerned about leaving tax-free money for their beneficiaries are probably among the best candidates for a Roth—and Roths don't have required minimum distributions for original owners like IRAs. Those who inherit Roths should be aware of recent changes that require certain beneficiaries to empty the Roth account within 10 years of the original holder's death. Which just goes to show that tax laws are always in flux, and to bank on the tax advantages and rules of a Roth staying the same forever would be foolish.
Alexis Leondis is a Bloomberg Opinion columnist covering personal finance. Previously, she oversaw tax coverage for Bloomberg News.