Yesterday, the House of Representatives narrowly approved Paul Ryan’s budget. While the Senate quickly rejected this bill, one of the provisions seems to have bi-partisan support, and that is reforming the tax code. Many politicians have been advocating lower tax rates for all Americans in conjunction with eliminating deductions. Ryan’s budget calls for the elimination of deductions and simplifying the tax code to two rates, 10% and 25%. While this may be somewhat revenue neutral, it would simplify the code making it easier for everyone to complete their tax return.
Unfortunately, if something like this gets through Congress it could have a real impact on those taxpayers who have chosen to convert their IRA accounts to Roth IRA accounts over the past several years. Let’s review how this works. Currently, when I convert my IRA to a Roth IRA, I pay taxes today on the conversion amount. In return, all of my IRA funds go into a vehicle (Roth IRA) that will be tax-free for the rest of my life. Why would I do this? Mainly, if I think either a) my income will be the same or higher in retirement and/or b) my tax rate will be the same or higher in retirement, then Roth IRA conversions could make sense. You would pay taxes now at a lower rate versus waiting and paying taxes at a higher rate in the future.
This second point has been one of the driving factors why Roth IRA conversions have been gaining popularity. The thought process is that the government has a debt problem and at some point tax rates will have to go up in order to pay for this massive debt. Case in point, Congress allowed taxes to go up on wealthy Americans this year by not extending the Bush tax cuts. But this budget proposal could nullify all of the value that individuals who converted to Roth IRAs thought they were gaining. Tax rates would go down, not up, and deductions would be curtailed. If I converted my IRA to a Roth IRA because I am currently in the 25% tax bracket and I will be in the 28% tax bracket in retirement, I would be extremely upset if the new tax law finds my marginal tax rate at 10%. I will have essentially paid tax at a high rate to convert my IRA to a Roth IRA, only to find that if I had kept my IRA intact, I could have paid taxes at a much lower rate in retirement.
Tax planning well into the future is difficult because we have no idea what the laws may look like. It would be wise for individuals to consider all of the risks (including legislative) when planning for the future.
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