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Investment Planning |
Converting a Traditional IRA to a Roth IRA
The Basics
Roth IRA conversions are gaining popularity, thanks to the removal of the income cap on conversions. Prior to 2010, only individuals with modified adjusted gross incomes of $100,000 or less could convert. It’s very likely that there will be a one- or two-year extension of the Bush tax cuts for those who earn more than $250,000, making it less imperative that a conversion occur in 2010 to take advantage of historically-low tax rates. However, your situation should be reviewed closer to year-end with your tax accountant.
A Roth IRA allows your principal and earnings to grow completely tax-free, because contributions are made to a Roth IRA after tax. Key benefits of a Roth IRA are that distributions are not mandatory during your lifetime, and distributions made after age 59 1/2 and in a few other circumstances (such as a first-time home purchase) are not taxable.
In comparison, contributions to a Traditional IRA are generally tax deductible, and the income and earnings in a traditional IRA are eventually subject to income tax at ordinary rates as distributions are received. When you turn age 70 1/2, you must begin taking distributions from the traditional IRA, based upon your life expectancy.
Funding a Roth IRA may be done either through annual contributions of $5,000 ($6,000 if you are over age 50), or by converting your traditional IRA to a Roth. Beginning in 2010, there are no income limitations on individuals converting to a Roth IRA. Income limits were lifted as a way for the U.S. government to raise tax revenue that may otherwise have been locked inside IRAs for many years. The conversion process includes paying tax on the value of the traditional IRA, since assets in the traditional IRA have not yet been taxed.
Are You a Good Candidate for a Roth IRA Conversion?
If you meet all of the following criteria, you may be a good candidate for a Roth IRA conversion:
- You have a long time horizon, and
- You expect to be in the same or a higher income tax bracket in retirement than you are in the year of the conversion, and
- You have non-IRA assets from which to pay the conversion taxes (allowing the tax amount to grow tax-free inside the Roth).
Alternatively, you may be a good candidate for a Roth IRA conversion if:
- You have high tax deductions relative to your income (perhaps because of retirement or temporary unemployment), and you are losing the full benefit of your deductions, or
- Your traditional IRA required minimum distributions (RMDs) exceed your expenses in retirement, and your heirs are not a charity (since a charity pays no income tax on an inherited IRA).
Paying the Conversion Tax
If you convert in 2010, you'll pay the tax on the conversion over two years -- in tax years 2011 and 2012. Alternatively, you may elect to include the Roth IRA conversion tax in your 2010 gross income (i.e., the year of the distribution). If no election is made, the two-year spread will apply. Since it's very likely that tax rates are headed higher, you may not want to defer the tax, especially if you earn over $250,000 per year. Conversions done after 2010 will generate a tax liability in the year of the conversion (no deferral will be available). If you elect to recognize the income in 2010, estimated tax payments may be due for the quarter when the conversion occurs.
Other Factors to Consider Before Converting to a Roth IRA
Questions that should be addressed before deciding to convert or not to convert include:
- What is your expected tax bracket in retirement? Consider how various sources of retirement income (e.g. Social Security, pensions, portfolio distributions, etc.) will affect your tax bracket. Converting to a Roth IRA will likely reduce your taxable income and therefore your tax bracket in retirement, as your required minimum distributions will be lower or eliminated. This is one reason the Roth IRA conversion is potentially a "Catch-22" situation (i.e. converting now and paying tax at your current tax bracket, then having a low tax bracket in retirement because RMDs are not mandated).
- Will you move to a state with either higher or lower income taxes than the state you now live in? Moving to a lower-tax state makes a Roth IRA conversion less attractive.
- Will your children or a non-spouse in a lower tax bracket inherit your traditional IRA? If so, consider the following scenario to illustrate why a Roth IRA conversion would be a poor financial decision. You convert your traditional IRA to a Roth and pay the conversion tax at your (high) tax rate. Some years later after your death, your non-spouse heirs inherit your Roth IRA. Since inherited Roth IRAs are subject to the same distribution rules as inherited traditional IRAs, your heirs will take required distributions from the Roth IRA but pay no tax (since most Roth IRA distributions are not taxable). If you had not converted, you pay no conversion tax, and the inherited traditional IRA is passed on to your heirs. Those low-tax-bracket heirs will take annual distributions from the traditional IRA they inherited from you (as they would with a Roth IRA), and pay tax at their lower tax rate. In this situation, a Roth IRA conversion may not make sense.
- What is your life expectancy? If the time horizon of your IRA assets is very long -- you have a long accumulation period to grow the IRA assets and then a long distribution period when you take RMDs -- consider the likelihood of changes in both elected officials and tax rates during the lifetime of your IRA assets (i.e. during your lifetime and the lifetime of your non-charity heirs).
- Would you like to reduce the value of your gross estate for estate tax purposes? The income tax paid at the time of the Roth conversion will reduce your gross estate. In effect, you are prepaying income tax on behalf of future beneficiaries without it counting as a taxable gift.
- If you are already 70 1/2, you cannot convert amounts that must be distributed from your traditional IRA for a particular year under the RMD rules. However, you can convert the balance of your IRA.
Partial Roth IRA Conversion
If you think you're a good candidate for a Roth IRA conversion, but have concerns about future tax rates and whether your assets can sufficiently fund a comfortable retirement, consider a partial Roth IRA conversion. A partial conversion will spread out your risk, allowing you to diversify your assets into various tax buckets. You'll then have taxable assets (in brokerage accounts), tax-deferred assets (in IRAs and company-sponsored retirement plans) and tax-free assets (in Roth IRAs).
Un-Converting
It is possible to make a Roth IRA conversion and later change your mind. However, the window for this "recharacterization" must be done by the extended due date of your income tax return. For conversions in 2010, you have until October 17, 2011 to un-convert.
Next Steps
The Roth IRA conversion rules are complex. We have discussed this planning strategy with our clients at annual review meetings. For those clients who have already converted, we will analyze the election option (payment in April 2011) versus the default payment over tax years 2011 and 2012 prior to finalizing tax returns.
For more information about Roth IRAs, please see the articles we wrote on Roth 401(k) plans and estate planning using a Roth IRA.
Tips Disclaimer
These tips contain information that may change over time as a result of new tax legislation. Although we make efforts to keep this information current, you should check with your tax advisor before taking action based upon any information contained in these tips.