We often hear from readers fearful that ever-increasing federal spending will inevitably increase their future income tax burden. While the recent election suggests that tax policy may change in the near future, the outcome of even near-term legislation is uncertain. Predicting tax rates ten or twenty years down the road is virtually impossible, and as ill-advised as predicting the stock market.
Future tax rates nonetheless loom large in decisions investors face today. The decision to convert your traditional IRA to a Roth IRA is a case in point. Distributions from traditional IRAs are subject to income taxes, but Roth distributions are not. IRA assets can be converted to a Roth, but income taxes are due immediately on the amount converted. So, other things equal converting today makes sense if you expect current tax rates to be lower than future tax rates. The prudent IRA owner, however, should think carefully before converting to a Roth under any circumstances.
Whether you end up better off through a Roth conversion comes down to how much you pay at the margin. Future lawmakers could increase marginal tax rates, in which case a Roth conversion may make sense. But higher tax revenues could also be pursued through eliminating deductions while leaving intact or reducing marginal rates. In that case, the taxpayer’s future effective tax rate might indeed be higher, but the marginal rate may be the same or lower. Under that scenario it would be advantageous to refrain from converting.
When it comes to taxes investors should ignore political theatre but pay close attention to actual changes in the law (for example, municipal bonds may become attractive if marginal rates rise). Otherwise the best defense against tax risk, as is the case with market risk, is diversification. Specifically, investors can hold both traditional and Roth IRA accounts, perhaps by executing a partial conversion.
Also In this Issue of Investment Guide
Year-End Tax Considerations
Evaluating After-Tax Returns
Liquidity, Gold and Your Home
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow Jones Industrials Ranked by Yield
Recommended Investment Vehicles
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