If you’re like many Americans, you may be worried that an ability of the politicians in Washington to cut a deal could lead us over the so-called “fiscal cliff,” in which the Bush tax cuts would expire for everyone. While you can’t do much about the taxes on your income, you can at least protect your retirement accounts from higher tax rates in the future by converting them into tax-free Roth accounts by the end of the year. (In addition, many employers are allowing employees to convert pre-tax money in their current retirement plans into Roth accounts.) This conversion would allow you to pay taxes on the money at today’s relatively low rates and avoid the higher future rates. But does it make sense for you?
Rather than taking a guess, you can use a Roth IRA conversion calculator like this one. With any calculator like this, it’s garbage in, garbage out so here are some guidelines to follow. For the number of years to receive income, you can estimate your life expectancy based on your family history, health, and lifestyle here. Since most people invest more conservatively in retirement, you’ll probably want to use a lower return on savings during the distribution period (5 or 6%) than the accumulation phase (7 or 8%). Finally, you can use this chart to determine your 2012 tax bracket based on your income. So far, so good.
The mistake that people tend to make is using a similar tax chart to estimate the future tax rate on their withdrawals. The main problem isn’t just that their income will change in retirement or that brackets may have changed by then. Most people are generally aware of those factors.
Rather, the chart will tell you your marginal tax rate but not your effective tax rate. The current marginal tax rate is useful because that’s the rate that your conversion will be taxed at (unless the amount pushes you into a higher tax bracket). However, when you withdraw money from your account in retirement, it’s not all going to be taxed at that marginal rate. Because of the way the tax code is structured, a lot of your money will end up getting taxed in those lower brackets.
For example, let’s say you’re a single person earning $40k a year and are considering converting $40k in an IRA to a Roth. If you convert that money, all $40k will be taxed at your 25% marginal tax rate. But if you don’t convert it and withdraw that same $40k as your retirement income (you’ll need more income in retirement because of inflation but the rates are adjusted for inflation too so it’s a wash), the first $8,700 would be taxed at only 10% and the next $9k would be taxed at 15%. Only the last $22,300 would be taxed at your 25% marginal tax rate. Since you paid $7,795 in taxes, your effective tax rate in retirement would be about 19%. (For sake of simplicity, we’re ignoring other retirement income and deductions and exemptions.)
So without having to do all that math, how can you project your effective tax rate in retirement? This nifty calculator from the Tax Foundation let’s you estimate your effective tax rate based on your various sources of income and deductions. It even lets you see what it would be if we go over the fiscal cliff, adopt Obama’s policies, or adopt the Republican policies. Plug in your expected retirement income and voila…you can see your effective tax rates under each of those scenarios. You even get a personalized link that will let you come back to your calculation later.
Once you have your effective tax rate in retirement, you can enter it into the Roth calculator and see whether doing the conversion makes sense. What you’ll probably find is that whether we go over the fiscal cliff doesn’t actually make much of a difference. But if it got you thinking about whether to do a Roth conversion, it was one potential crisis that didn’t go to waste.