Should you convert your traditional IRA to a Roth? The definitive answer is...it depends.
The conversion hype of 1998, the year Roths were introduced, left a lot of people wondering whether they would miss the boat by not converting. One reason was the tax advantage of converting in 1998 (the tax hit could be spread over four years), which is no longer the case. There was also the "everyone's doing it" factor.
But experts say a conversion from a traditional IRA, which may contain tax-deductible contributions, to a Roth, which is funded entirely by after-tax contributions, should not be entered into lightly. You should carefully examine the tax consequences and determine how a conversion would fit in with your long-term financial goals.
Avoid "Sound-Bite" Answers
There is a lot of common wisdom floating around as far as who should convert and who shouldn't. But "we need to avoid sound-bite answers," said Bob Skomars, an IRA expert and consultant for Universal Pensions, Inc. "This is very intricate and there are a lot of variables."
|"We need to avoid sound-bite answers...there are a lot of variables."
|- Bob Skomars,
For many people, converting a traditional IRA to a Roth IRA makes sense. You pay taxes right away on the pre-tax contributions that are in your traditional IRA, but if you follow the rules, you won't have to pay any taxes when you withdraw the money. Generally, the younger you are, the more chance you will have to benefit from a conversion to a Roth IRA, because you have more time to make up for the tax hit, and your dollars have a longer time to benefit from compounding.
However, there are some cases in which you might not want to convert.
- If you expect to be in a lower tax bracket when you retire.
- If the income you declare from the conversion pushes you into a higher income tax bracket, thereby disqualifying you from certain tax breaks in that year.
- If you think you'll need the money soon. This leaves you less time to make up for the conversion tax hit.
Additionally, if your income is over $100,000, you aren't allowed to convert your traditional IRA to a Roth IRA .
It's a good idea to seek advice from an expert before carrying out a conversion.
Deadline and Income Limits
The deadline for converting in any given tax year is December 31. In order for the conversion to be valid, your income for that year cannot be more than $100,000. That's the limit -- for singles AND couples filing jointly -- for converting to a Roth. So, if you decide that a conversion is a good idea but you expect your income to go above the limit next year, be sure to act before December 31.
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In 1998, there was additional urgency to convert by December 31 in order to benefit from an additional tax break -- the tax bill could be paid over four years instead of all at once. That is no longer the case. Any taxes you owe on a 1999 conversion are due in full with your 1999 tax return, and so on for subsequent years.
Taxes Now or Later?
Converting means paying taxes now rather than later. Deciding whether this is the right thing to do is really an individual matter. Here are some of the factors you need to consider:
- Is your current tax rate higher or lower than your expected tax rate when you plan to withdraw the money?
- How much time remains before you plan to withdraw the money? In general, the longer your time horizon, the more time your account has to recoup the tax hit.
- Do you consider it important to make tax-free income part of your retirement financial plan, in addition to your taxable 401(k) and traditional IRA distributions?
For those with a long time horizon until retirement, conversion may seem the obvious thing to do. Elizabeth Allen, a Michigan certified financial planner, urged her teenage son to convert his traditional IRAs to Roths when the new accounts became available in 1998.
"I wanted him to pay tax at a 15% rate instead of 28%" or whatever tax bracket he is in later, she said.
|"I figured I'd convert one-third and take my chances that the tax laws won't change."
|- Russell Hall,
Certified Financial Planner
But Russell Hall, a 45-year-old Wichita, Kansas CFP, was a bit more cautious. Of course, he also had more at stake than a 19-year-old student would.
"Of $150,000 of IRAs I had that were eligible to be converted, I converted $50,000. I figured I'd convert one-third and take my chances that the tax laws won't change." Hall looks forward to having some tax-free income at retirement, but he wants to play it safe in case Congress decides to change the rules.
Will Congress Change the Rules?
Some experts warn that Congress could change the Roth IRA rules later, eliminating the benefit of these accounts. In Hall's opinion, if a lot of people take advantage of Roth IRAs, Congress may decide one day to change the rules to get its hands on some of that "lost" tax money.
Of course, there is no way to know for sure what Congress will do in the future.
More Than Meets the Eye: Tax Consequences
You should make sure you understand the tax consequence of converting. It's not as simple as it might appear, especially if you own more than one IRA. This is because the taxable portion of the IRA (or portion of an IRA) that you convert will be determined based on the proportion of taxable money in all your traditional and SIMPLE IRAs combined. Also, if you choose to do a partial conversion, don't think you can convert only the part of your IRA that you won't owe tax on. You'll have to pay tax, no matter what.
Here's an example: Say you have a traditional IRA worth $10,000, of which $8,000 is not taxable. If you convert it to a Roth IRA, how much will you have to pay tax on? If you said $2,000, you are correct if that is your only IRA.
A traditional IRA that holds only money from your 401(k) or other employer-sponsored retirement plan, while you wait to roll it over into a new employer-sponsored retirement plan.
But (and this is where things start to get complicated), say you recently quit your job and rolled over your 401(k), worth $70,000, into a conduit IRA. When you report your conversion on IRS form 8606, you have to put down the value of all your IRAs. Your IRAs together are worth $80,000 in total, of which $8,000, or 10%, is not taxable (your $70,000-rollover IRA is all pre-tax contributions and earnings from your 401(k).) So, when you convert your $10,000, you will have to pay tax on 90% of it, or $9,000, since your non-taxable contributions are only considered to make up 10% of your aggregate accounts.
"If you've got multiple IRAs don't think you can just look at the balance in the one IRA that you're converting in order to figure the tax on the conversion. You'll have to take all your traditional and SIMPLE IRAs into account," said Skomars. "Most people don't know this."
Estate Planning Advantage
With a Roth IRA, you won't have to take minimum distributions at 70 1/2 as you would with a traditional IRA. You'll have more flexibility to pass the tax advantages to your heirs.