Don't Rush Into Roth IRA Conversions

Last Updated Dec 2, 2009 6:10 PM EST

The hot topic these days in the retirement planning world is the Roth IRA conversion. Because conversions can generate new sources of money to manage, many firms are pushing the conversions as the best thing since sliced bread.

While there are some good reasons to consider a conversion, there are very few situations where the conversion is a slam dunk from a tax perspective. So take your time and don't rush into paying more taxes until you understand all the numbers.

What Is It? A Roth conversion allows you to take a traditional IRA and convert it into a Roth IRA. The difference between the two accounts all comes down to the tax treatment.
  • With a traditional IRA, you get an income tax deduction for the money you contribute to the IRA, but then pay income taxes on the value of the money you take out in retirement.
  • With the Roth IRA, you don't get a deduction for the money you contribute, but you don't have to pay tax on the money when you withdraw the funds in retirement.
If you convert a traditional IRA into a Roth, you can change a tax-deferred account into one that is tax-free. Sounds great, but to do the conversion, you have to pay income tax on the amount you convert.
  • Assume you have a $250,000 traditional IRA. If you convert it to a Roth IRA, you will owe income tax on $250,000, or about $75,000 in taxes assuming your tax rate is a combined 30 percent between Federal and state income taxes.
Analysis. The basic analysis comes down to predicting future income tax rates. Essentially, if you think you'll pay a lower income tax by converting today, as opposed to waiting and paying taxes in retirement, then you would convert.

For instance, in the above example, you paid an assumed 30 percent tax rate on the conversion. It would make sense to convert today if you were confident that when you retired, you would pay more than 30 percent in income taxes on the distributions from the IRA.

Thus, the decision to do a Roth conversion all hinges on your ability to predict future income tax rates, which is risky business. Unless you feel very confident that you'll be in a higher income tax bracket later, it may not make sense to accelerate all those income taxes and pay them decades before they're due.

Here are a few other things to consider:
  • Small Distributions. In retirement, you generally don't take all your money out at once. You're more likely to take smaller distributions of say 4 or 5 percent of your account each year. Thus, you may be in a lower income tax bracket in retirement than you were while working because you aren't taking large, taxable distributions.
  • Tax Brackets. Many people are predicting higher income tax rates, but you have to consider who might be hit by those rates. If there are increase, odds are the upper brackets will probably get hit. But middle tax brackets (which cover about 90% of all employees) may not be subject to higher income taxes. You have to assess the odds that your income tax bracket will be subject to higher rates in the future. And by the way, we could hit an era of higher rates, only to see rates come down 20 years later when you enter retirement. You have to consider that as well.
  • Other Taxes. While people are anticipating income tax hikes to cover the budget deficits, all the tax increases we get may not come in the form of income taxes. It's possible that to pay for retirement and ballooning health care costs, Congress increases FICA taxes (the Social Security and Medicare taxes), and not so much income taxes. When you're working, you pay FICA taxes on your wages. But when retired, you don't pay FICA taxes on money that comes out of your IRA. Thus, if Congress raised FICA taxes on middle income workers, as opposed to income taxes, you might be better off not converting today.
In any event, the point is you have to consider multiple potential outcomes with tax rates. And predicting future tax rates comes down to predicting who will have political power, and it's basically not possible to do with any degree of certainty. Thus, if you want to convert, the tax analysis needs to be pretty compelling to overcome the uncertainty about your future income tax status.

Slam Dunk? So is there ever a "slam dunk" situation where a conversion will make sense? Well, here are a few situations where a conversion may be more compelling:
  • If you're in a very low income tax bracket today (like 15 percent) and anticipate that later on you'll be in a much higher bracket (like 33 percent), a conversion may make sense. But remember, the amount of money you convert from the traditional IRA is added to your income for the year. So to stay in a low bracket, you wouldn't be able to convert that much.
  • You're retired and have a ton of money that you don't need for living expenses in retirement. In that case, you may want to convert a traditional IRA to a Roth because you could pass the money along to your kids or grand-kids income tax free. Now, remember, you have to pay income tax on the conversion. But if you have money outside of the IRA available to pay the tax, you could create a nice tax-free legacy for your kids. On the other hand, if your kids or grand-kids are in a tax bracket that's lower than your bracket, it may not be a good deal for you to convert. It may be better to let them inherit the IRA and pay the tax at their lower rate.
  • As you can see, there are many variables to consider.
Take Your Time. The reason you're seeing all of this activity around Roth conversions is because the tax laws are changing in 2010. Prior to 2010, there were income limits of about $100,000 on Roth conversions, which prohibited many people from considering them. In 2010, the limits are gone, so anyone can convert. But you don't have to convert right away.

You have plenty of time to run the numbers, and work with your tax and financial advisers to analyze the short term and long term consequences. And if someone offers to run the analysis for free, I would be highly skeptical. It may be more marketing than advice.

Partial Conversion. You also have the ability to do partial conversions. If you aren't sure which route is best, you could convert part of your traditional IRA over several years. That way you can hedge your tax bets on future rates, and get some tax diversification with your assets.

Bottom line. The Roth IRA conversion requires multiple layers of tax and investment analysis. Some people are using the conversion as a marketing tool, so take your time and make sure you pay for your own independent tax and financial analysis.

As with all tax matters, consult your individual tax advisor prior to making any decisions.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my upcoming book Your Money Ratios: 8 Simple Tools For Financial Security, available for pre-order at amazon.com
Your Money Ratios
  • Charlie Farrell

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