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Roth IRA Fear, Confusion Stymie Investors

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With all the talk of Roth IRA conversions, and the benefits of the two-year tax smooth, Congressional inaction on taxes is confusing investors.

As the Wall Street Journal’s Laura Saunders notes, even this year's alternative-minimum-tax level is up in the air. Investors are most at risk, because investments are facing higher percentage increases than other types of income in coming years.

One thing we know for sure, according to Saunders: This is the first year all taxpayers have been allowed to convert regular individual retirement account assets to Roth IRAs, regardless of their income. This year converters can take also take advantage of Uncle Sam's one-time offer to push conversion income into 2011 and 2012, taking half each year at then-current rates.

Although many have jumped to make the switch, others remain on the fence. They have one big fear: Lawmakers will find a way to tax Roth income in the future, especially given current budget pressures.

Saunders notes experts have pooh-poohed this fear for many valid reasons, but recently released deficit-cutting proposals give it a spark of life. Of course, the proposals are not detailed plans; instead, they are meant to serve as a wake-up call as to what it will take to cut the deficit.

Still, she writes, two of four proposals would lower the top income tax rate and broaden the tax base so to raise revenue. In one case the top rate would be 23%, and in the other 27%.

These proposals are far too sketchy to mention Roth IRAs. But they raise the question: If top tax rates go down, might taxpayers regret paying conversion taxes at the current top rate of 35%?

Saunders says too many variables are in play to provide a definite answer, including what exact changes—if any—will happen and when, and what the growth rate on the money has been before that time. Those worried by this issue may want to proceed cautiously by making smaller, partial conversions. All taxpayers should keep in mind the general factors that make success with Roth transactions.

She recommends that some may also want to consider postponing a conversion till January. That forgoes the one-time tax deferral option, but it leaves nearly 22 months to undo the transaction. By October 2012, the budget and tax picture may be much clearer than it is now.