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Wait and See on Taxes and Roth Conversions

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I'm here in Vanguard's office with Maria Bruno. She is an investment analyst for Vanguard. Maria, thanks so much for sitting down with us today.

Maria Bruno: Thank you Christine.

Benz: So, Maria, you've written and talked a lot about converting a traditional IRA to a Roth IRA. Curious to hear whether Vanguard is seeing a decent rate of adoption of Roth conversions.

Bruno: Conversions this year, yes.

Benz: Yeah.

Bruno: Actually, Christine we have, and we did see an uptick earlier in the year, which was expected as the income limitations were lifted early in the year. We expected to see an influx of conversions, and we did. I think year-to-date, we are seeing conversions up about five times greater than they were last year at this time. We do expect the momentum to continue as we get closer to the year end.

I think I like to stress that, while conversions may be good. We really want to make sure we have the right conversions. So our goal has been really to educate our investors through tools, calculators, education on the web, et cetera.

Benz: Right. So, one think I have been hearing from Morningstar.com users is that they are thinking about this option, if they do a conversion they can defer the taxes into 2011 and 2012.

Bruno: Yes.

Benz: And yet, tax rates are poised to go up in 2011. So, people are wondering, how should I think about that decision making? Do you have any tips for people in that situation?

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Bruno: Yes, it does add additional flexibility, but it could add complexity as well, too. By paying the taxes in 2010, we know what the tax rates are today. So, there are some certainty there. If nothing happens with the tax legislation, tax rates are set to go up in 2011. So, by deferring the tax, it's the 50/50 split across 2011 and 2012, and to clarify, it is any taxable income from the conversion that would be added to the income.

So potentially, if tax rates do sunset and go up, or if there is some type of change, you could actually, as an investor, end up paying more or a higher tax rate on the conversion than you would otherwise. The nice part is that you really don't need to make that decision until you actually file your tax return.

So at that point there may be more clarity around, either your particular situation or what may happen with the legislation in general. But if ... there maybe an atypical tax situation either in 2010 or across 2011-12, there is some flexibility to try and time when to report the income.

Benz: Right, right. So, you say, do the math, consult with the tax advisor to help.

Bruno: That's always a good idea, particularly if there is some uncertainties, and you are not really sure, or if your situation is a little bit in flux, it maybe a good idea to do so, yes.

Benz: Okay. Now I want to talk to you about another thing, part of this Small Business Act that was passed just a couple of weeks ago included a provision that allowed some people to convert traditional 401(k) balances to Roth. Can you talk about that and how investors should think about that new option?

Bruno: Okay, yes. On Sept. 27, as part of the Small Business Jobs Act, in-plan conversion from a traditional 401(k) to a Roth 401(k) were part of the provisions. I guess a few important things to note there is that first, the plan must offer Roth 401(k) deferrals and then the plan also needs to be amended to allow Roth conversions.

So, from a planned sponsor's standpoint there are some steps. From a participant's standpoint, really the only people who can take advantage of that is, if they actually have access to that money. You need to be able to do a direct rollover or a distributable event. For instance, separation from service or in-service withdrawals, for instance at age 59 and a half, or if you can take the after-tax monies out.

So, it limits the audience of people who can actually take advantage of this conversion option within the plan. Beyond that, prior to the plan, these individuals had the same option to actually go out of the plan and do a Roth IRA conversion.

So, I think the first question is, should you do the conversion or not, and weigh the trade-offs there and make that decision. The secondary decision then is if your plan allows it to weigh the tradeoffs between keeping the monies in the plan versus rolling it out into an IRA.

It is an individualized decision. Certainly, with an IRA you may have more flexibility for investment provider, investment selection. There is no RMDs, for instance, with a Roth IRA, whereas with a Roth 401(k) there are. But as a participant, you may have particular features or options within the 401(k), that may be important. So…

Benz: A stable value is a common one, that is--

Bruno: There maybe, or a particular share classes. So, it's a very individualized decision beyond that as far as what might be right.