To Convert or Not to Convert —That is the Question

In recent months, the Roth conversion opportunity has dominated the headlines. Thanks to a provision in the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005, the $100,000 income restriction on Roth IRA conversion eligibility was lifted as of January 1, 2010. This opens the door to a tax planning opportunity for millions of taxpayers who currently hold well over $1 trillion in tax-deferred IRA and defined contribution plan assets.

I’ve been discussing with you the potential advantages of converting your traditional IRA or 401(k) plan with previous employers to a Roth IRA. However, now that we can do so, there are plenty of questions. In fact, in the last quarter of 2009, the number of people “Googling” the phrase “Roth IRA conversion” tripled compared to January 2009. Interestingly, however, despite the spike in interest, surveys I’ve read indicate only about 10 percent of investors are ready to convert.

As I’ve said before, the conversion opportunity comes down to analyzing whether it’s beneficial to pay taxes now as a way to potentially avoid paying more taxes later. Free conversion tools are popping up on scores of mutual fund and personal finance sites, but they cannot possibly factor in all the issues to consider in your personal situation. These calculators often present an all-or-nothing decision and, for most of us, the decision of whether to convert is not that straightforward. Moreover, it certainly won’t surprise you that I’m not sold on any rules of thumb or general advice being offered in personal finance magazines.

As background, for those working to build and retain retirement capital, a Roth offers three major benefits:

  • Tax-free growth that is especially attractive, considering income tax rates are likely to go up in the future
  • Tax diversification that provides flexibility in retirement income distribution planning
  • No required distribution at age 70½, which helps transform your retirement savings into a financial legacy

Accordingly, the question should not be “Should I convert?”, but should be twofold: “What are the benefits of converting?” and “If conversion makes sense, what is the ideal amount to convert?” Your answers will depend on a comprehensive analysis of your current personal finances and assumptions about your future tax liability. Specifically, you should consider the following:

  • Projected income needs relative to overall retirement savings. Roth IRAs do not mandate required minimum distributions (RMDs) at age 70½. So, if after calculating your sources of retirement income (such as IRAs, 401(k)s, Social Security, and pension benefits), you determine you will need less annual income than your projected RMDs, a partial Roth IRA conversion may be beneficial. Further, not taking RMDs may keep you below the threshold where your Social Security benefits would be taxed or help you avoid higher Medicare premiums, which are tied to income levels. Conversely, if you are eligible for Medicare when you convert to a Roth, your Medicare premiums could increase due to the higher income from conversion.
  • Future tax rates. While no one can say with absolute certainty how personal income tax rates will change in the future, a good case can be made that the top marginal tax rates are likely to go up given our increasing federal budget deficit and the fact that top marginal tax rates are now historically low.
  • How you will pay the tax bill. If you have assets you don’t need in a savings account earning a very low interest rate, conversion would seem the obvious choice. If you don’t, you need to carefully weigh the benefits of paying taxes now with assets you have at work elsewhere. Note that anyone under age 59½ will generally be subject to a 10-percent early withdrawal penalty on IRA distribution amounts that are directed to pay the taxes related to a conversion. Keep in mind, too, that there is a special tax incentive for conversions made during the 2010 calendar year. Specifically, federal law allows taxpayers to delay taxes by electing to include the taxable portion of the 2010 conversion ratably in taxable income for 2011 and 2012. Thus, if you converted a $100,000 IRA in 2010, you could choose to report $50,000 in ordinary income in 2011 and $50,000 in 2012. If you complete a Roth IRA conversion in 2011 or beyond, you cannot spread the income or tax bill over two years.

Generally, the best candidates to convert would be:

  • Affluent investors who can pay for the tax of conversion from non-retirement assets and do not need to withdraw money from retirement accounts to fund retirement
  • Young investors in the lowest tax bracket who can harness the power of tax-deferred growth and likely will be in a higher tax bracket in retirement
  • Parents or grandparents who are in a lower tax bracket than their heirs and who plan to leave retirement accounts to their heirs
  • Investors who are temporarily in a lower tax bracket this year due to unemployment or some other temporary situation that will result in lower income in 2010

If, in determining whether to convert to a Roth, you are assuming you will be in a lower tax bracket in retirement, there are variables to consider. For example, you might be planning to retire to a state that does not have income taxes. Conversion could also increase your annual income and push you into a higher tax bracket, potentially causing you to lose some or all of your personal exemptions and itemized deductions. Finally, we cannot predict with certainty where tax rates will be in 20 years. Who would have forecast that the tax rates would be so much lower now than they were in the 1970s?

While I encourage each of you to meet with me personally to discuss the conversion question, here are answers to several frequently asked questions:

  • What if I convert and later feel I’ve made a mistake? Amazingly, you have until October 15 of the year following your conversion to do a Roth “re-characterization” and change your account back to a Traditional IRA. Note, however, if you decide to undo the Roth IRA conversion and have used the funds from your initial IRA to pay the taxes, that amount cannot be part of the re-characterization. For example, if you withdrew $100,000 out of your traditional IRA and rolled just $80,000 into a Roth, you only have $80,000 to re-characterize.
  • What about the Roth’s five-year rule? With a Roth IRA, withdrawals are tax-free once you’ve owned the account for five years and have reached the age 59½. When you do a Roth IRA conversion, the five-year rule takes effect at the conversion date.
  • Can I convert my 401(k) to a Roth IRA?  Maybe. According to IRA expert Ed Slott’s July newsletter, plan participants in 401(k)s, 403(b)s, and 457 plans can do Roth conversions as long as they are eligible to take a distribution from their plan and the funds are eligible for rollover to an IRA. Check whether your plan allows in-service distributions.

Remember, unlike many changes in tax law, the lifting of the $100,000 income limit for a Roth conversion is not set to expire on a future date. Accordingly, you have time to weigh your options carefully.

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