The Roth IRA roll: A quiet explosion in IRA conversions

In the long run, turning billions of dollars from tax-deferred to tax-free savings through the tax change will be a huge loser for Treasury.

Back in 2005, Congress gave many high-income savers a great gift, with the proviso that they couldn’t unwrap the package until this year. The bequest allowed the affluent to convert their traditional tax-deferred Individual Retirement Accounts into tax-free Roth IRAs. Now that these lucky investors have torn open the box, we’re beginning to learn what this opportunity will mean both for them and for federal revenues.

I asked the folks at financial services giants Vanguard and Fidelity how clients were responding. And they say there has been tremendous interest. At Vanguard, nearly 100,000 converted though May, five times the normal pace. And most were wealthier investors. Fidelity clients have converted four times more frequently this year than last. A Fidelity survey of tax advisers reported that more than 40 percent of roll-overs have been for accounts of $50,000+. And this may be the bow of the wave. Both firms expect a bigger spike in conversions once clients focus on tax planning later in the year.

This new interest in Roths is hardly a surprise. Until this year, only those earning less than $100,000 could convert a traditional IRA (or an inactive 401(k) from a former employer) to a Roth. Now, anyone can do the roll, regardless of income. The one catch: They must pay tax on the conversion as if it was a withdrawal.

Still, converting to a Roth has big benefits. Future earnings will be fully tax-exempt. This is especially valuable these days, when stock prices are still relatively cheap and account values are low. In contrast to ordinary IRAs, investors do not have to begin withdrawals at age 70½, so their tax-free savings can grow for longer. Not only can wealthy investors roll traditional IRAs into Roths, they may also be able to make future contributions to these tax-free accounts (although in an indirect and somewhat convoluted way). Finally, doing the Roth roll allows taxpayers to lock in today’s relatively low tax rates, especially if they think (as I do) that rates will surely rise.

The decision to convert is not clear-cut. You'll need cash to pay the upfront tax (if you use funds from inside your IRA, you’ll have less to put in the tax-free account and lose most of the benefit of the rollover). Moreover, since the converted account is treated by the IRS as income, the roll could throw you into a higher tax bracket. While the law allows those who convert in 2010 to spread their tax over 2011 and 2012, top rates will almost surely be higher following the expiration of the Bush tax cuts at the end of this year. Still, shifting to a Roth can be a great deal for some wealthy savers.

It is no bargain for the government, however. Congress adopted the tax change in part as a fiscal gimmick. That’s because, within the 10-year budget window (all that matters in Washington accounting), the conversions raise revenue. At the time the law passed, CBO figured it would generate about $6.5 billion from 2010-2015. But in the long run, turning billions of dollars from tax-deferred to tax-free savings will be a huge loser for Treasury. My colleagues at Tax Policy Center figure that, through mid-century, allowing unlimited Roth conversions will reduce federal revenues by $100 billion ($15 billion in net present value).

Still, the Siren Song of the Roth seems too much for government to resist. For instance, the Obama Administration will soon propose making Roths, rather than old-style tax-deferred IRAs, the default form of retirement saving.

This infatuation with all things Roth bears close watching. Last month, the Congressional Budget Office estimated that between 2010 and 2035, projected revenues would rise by 0.5 percent of GDP thanks to deferred taxes paid on defined benefit retirement plans. That's serious dough--about $75 billion in today's money. It’s great that Congress wants to encourage private savings. But giving wealthy investors a long-term tax windfall on money they have already put away is hardly the best way to accomplish this laudable goal.

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