Roth IRA: Should You Convert?

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Last Updated Jan 6, 2010 11:22 AM EST

Among the Big Questions you may ponder — Is there intelligent life on other planets? Why do children whine? Does Rush Limbaugh have a soul? — the new year ushers in another query of great import: Should you convert your IRA to a Roth?

As of 2010, a tax law change allows savers of all income levels to convert, a big change from the previous rules that only allowed the move for households with incomes below $100,000. Though on the surface it is nothing more than a tax designation named after a senator from Delaware, a Roth is a thing of accounting beauty. It can help feather your nest egg, provide more flexible income streams once you retire, and reduce your heirs’ tax bills — in short, one of the smartest money moves you can make this year.

So now’s the time to figure out whether a conversion makes sense and, if so, where you’ll get the money to pay the taxes for it. Just prepare for the barrage of “Convert now!” hard sells from financial services companies, who are eager to help you make the move in the hope of getting your assets from the company now holding your IRA.

IRAs vs. Roth IRAs

Before laying out the pros and cons of conversions, a brief IRA refresher course. In a traditional IRA, earnings grow tax-deferred but you are taxed when you take the money out. Contributions may be tax-deductible, depending on your income and whether you have a retirement plan at work. With a Roth IRA, there’s no upfront deduction, but earnings grow tax-deferred and — here’s the real beauty — withdrawals are not taxed.

So the advantage of converting is that all future growth in your IRA will become tax-free. The drawback: After the conversion, you’ll need to pay income taxes on the gains you’ve built up in the old IRA. In the case of a deductible IRA, or a rollover IRA from a 401(k), you’ll have to pay tax on much, if not all of the money you’ve converted. (For this year only, you’ll be able to spread the tax bill over a two-year period.)

Many financial advisers are downright giddy at the prospect of Roth IRA conversions for clients, noting the move could prove especially profitable if tax rates rise to shrink the ballooning budget deficit. Roth IRA owners won’t need to worry about their retirement stashes getting socked by higher tax rates. “I’m a fan,” says Nate Wenner, a financial planner in Minneapolis with Wipfli Hewins Investment Advisors. “It’s going to be a good deal for a lot of clients.”

But will converting to a Roth IRA be a good deal for you? That depends on a number of assumptions about the future, plus your cash flow needs. Here are the factors to consider.

Run the Numbers

Linda Duessel, equity market strategist for Federated Investors and an accountant, believes the best candidates for conversion are people earning more than $500,000 a year. That’s because the very wealthy, already paying the top 35 percent marginal rate on a high percentage of their income, won’t see much benefit delaying the taxes on their IRA gains. Only a small portion of their income will be taxed at the lower brackets in retirement.

But retirement adviser Ed Slott, who calls his group of advisers “America’s IRA Experts,” thinks many more than just the very wealthy would benefit from converting in 2010. “There are probably more [newly eligible] people who should convert than shouldn’t,” he says. He considers taxes owed on IRAs a “mortgage’’ on retirement and believes that if you can pay them early, you should.

Your decision will be based largely on whether you think your tax rate will rise by the time you retire (rising rates make a stronger case for converting) and partly on how much you estimate your retirement stash will earn in the future. The higher your portfolio’s average annual return, the stronger the argument for a Roth conversion. Take a 45-year-old in the 33 percent bracket converting $100,000 who expects to retire at 65 in the 28 percent bracket. If his portfolio averages 8 percent annually after converting, he’d have $3,510 more after taxes at 65 than if he didn’t convert. But if the portfolio averages only 4 percent, he’d have $3,054 less. So he would be better off leaving his traditional IRA alone.

Free online calculators at bankrate.com, dinkytown.net and Investorsolutions.com can help you pencil out whether to convert. You plug in figures including how much you have to convert, your age, your current tax rate, when you expect to retire, what you think the money will earn and your anticipated tax rate in retirement. (Assume the money will earn about 5 percent a year for a conservative portfolio; to estimate your retirement tax rate, assume that you’ll live on 80 percent of your pre-retirement income and then find the current federal tax rate for that amount.) Once you’ve put in the numbers, the calculator spits out your net return from the Roth IRA if you convert and the Traditional IRA if you don’t.

Consider Your Cash Flow

But the Roth IRA conversion decision goes beyond the numbers.

You might prefer paying the conversion taxes now because of the peace of mind from knowing the Roth IRA will deliver a tax-free income stream in retirement, says Slott. Or you may like not being forced to withdraw money from your IRA in retirement. Unlike traditional IRAs, which require you to withdraw a minimum amount each year starting at 70 , Roths have no minimum-distribution requirements for you or your heirs. That lets you keep all the money in the IRA growing tax-free, if you won’t need the cash for retirement income.

Another consideration is whether you have enough money on hand to pay the taxes on the conversion, says Leon LaBrecque, managing partner at LJPR, a Troy, Mich., advisory firm. You probably won’t want to sell investments — and pay tax on them — merely to cover a tax bill. The taxes should come out of liquid savings. To limit your tax liability and prevent you from having to dip too much into savings, Labrecque advocates converting just enough to stay in your current tax bracket.

But keep in mind that the IRS doesn’t allow you to “cherry pick” which IRA assets to convert. If you have made deductible and non-deductible IRA contributions, you can’t simply choose to convert the non-deductible ones to avoid tax, says Slott. Conversions follow the pro-rata rule, which means any money coming out of the IRA is taxed according to the ratio of non-deductible and deductible contributions you have in all your IRA accounts.

If you don’t want to make a big bet on future tax rates, you could follow MoneyWatch blogger Allan Roth’s suggestion and keep some money in a traditional IRA and some in a Roth. That way, he says, you diversify against the unknown. One way to do this is by swapping just enough each year that the converted IRA gains won’t throw you into a higher tax bracket.

And if you decide to convert, be sure you don’t dip into the IRA to pay the taxes. First of all, it’s counterproductive: you’re cannibalizing your retirement savings in order to increase your retirement savings — don’t bother. What’s more, if you’re under 59 , you’ll owe a tax penalty. Just as in football, you never want a penalty called on a conversion.

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