Is it Time to Convert to a Roth IRA?

By Jill L. Shattler, CFP^®
Partner
Trust Company of Illinois

Beginning in 2010, the IRS will be removing a roadblock that has kept many high income investors out of Roth IRAs.  Will converting your traditional IRA or qualified plan to a Roth be the right move for you?  A review of the basics will help you make the right decision.

Traditional IRA accounts are allowed to grow tax deferred until the owner reaches age 70½.  This means that no current income tax is due on the income or capital gains generated by the account.  In addition, for those who do not participate in a qualified plan, all contributions are tax-deductible. For qualified plan participants, income limits apply to determine if a contribution is deductible or not. At age 70 ½, IRA owners are required to withdraw an annual amount, and all distributions are normally taxable.

Roth IRA accounts, on the other hand, are funded with after-tax dollars, and all earnings accumulate tax-free.  As long as the earnings remain untouched for a five-year waiting period, and the owner reaches age 59 ½ , all distributions are also tax-free. There are no required minimum distributions for Roth IRA owners, which means the funds are allowed to grow tax free for a much longer period of time.  Only non-spouse beneficiaries of Roth IRA accounts must take required minimum distributions, but the funds received still remain free of tax, providing the original owner had satisfied the 5-year waiting period.

Since 1997, full Roth contributions could only be made by taxpayers who fell below certain income limits ($105,000 for single taxpayers and $166,000 for couples filing jointly in 2009.)  Rollovers from traditional IRAs to Roth IRAs have been only available to those whose modified adjusted gross income didn’t exceed $100,000.  Starting in 2010, this $100,000 conversion limit has been permanently lifted, allowing high-income taxpayers to now take advantage of Roth IRAs.  In addition, for 2010 only, taxpayers can elect to report the income generated from a conversion entirely on their 2010 return, or they can defer it by reporting half in 2011 and half in 2012.

So who should take advantage of a Roth IRA?  Consider converting if:

You believe you’ll be in the same or higher tax bracket in the future
Converting now will allow your funds to grow completely tax free in an account that is safe from potential future tax increases.

You can pay the tax due with funds outside of the IRA
Paying the tax with IRA funds reduces the amount that can grow tax-deferred and, if you are under age 59 ½, the tax payment will be subject to a 10% early withdrawal penalty.  If you do not have other funds set aside for the up-front payment, converting is not recommended.

You have more than five years before you need to tap into the Roth
Taking a withdrawal within five years of a conversion will subject the earnings to an immediate tax.  So the longer you keep the funds invested, the more you can recoup some of the initial tax hit via tax-free earnings.  A good rule of thumb is that the younger you are, the more you will generally benefit from a conversion.

You are currently in a low bracket or have large or unused deductions
One popular strategy is to convert as much as possible to a Roth while still keeping yourself in the lower bracket, so that you are fully taking advantage of the lower tax rate.  Also, if you have large itemized deductions and not enough offsetting income to take advantage of them all, convert enough so that you are not leaving deductions on the table. Donating funds or appreciated securities to a charity will also create a deduction that can offset some or all of the income generated by a conversion.

You have a high percentage of after-tax dollars in your IRA or qualified plan
A pro-rata portion of after-tax dollars is included with each distribution from an IRA or qualified plan; if you have a large amount of after-tax dollars, the amount taxable upon conversion might be low.

You are looking for ways to reduce potential future estate taxes
Paying income taxes on the conversion not only lowers the value of your estate, but it also produces a lower combined tax than if estate taxes are paid first, and then income taxes are paid on the IRA after your passing.  Creating a Roth IRA therefore helps you avoid paying estate tax on the deferred IRA income taxes.

You don’t need the income from your IRA required minimum distributions
If you won’t need to rely on the funds generated by your required minimum distributions for living expenses or another use, it might make sense to convert to a Roth so the benefits of tax-free growth can compound for a longer period of time.  A Roth will also provide a great source of tax-free income to your beneficiaries. 

Of course, Roth IRAs are not right for everyone.  A Roth conversion might not be advantageous if:

You believe your taxes will be lower in future years
If you will be in a lower tax bracket in the future, it is best to defer paying taxes as long as possible by continuing to hold your traditional IRA.

You will need to use IRA money to pay the up-front tax liability
The advantages of Roth conversions are negated when IRA funds are used to pay for the taxes due, because it reduces the amount that can grow tax-deferred.

You are over 65 and/or you’ve started receiving Social Security benefits
Conversions increase taxable income, which can cause a higher portion of your Social Security benefits to be taxed and can also result in an increased Medicare Part B premium.

You are leaving all of your IRA to charity
Naming a charity as the beneficiary allows your IRA to escape income taxes, so a conversion would not make sense in this situation.

Whether to convert or not is never an all-or-nothing decision. Often, a partial conversion will be the best strategy to control the amount of taxable income that is generated in any one year.  Because the income restrictions once in place have been permanently lifted, conversions can be made in tax years that make the most sense. The only real deadline for taxpayers applies to the one-time opportunity to defer 2010 conversion income out to 2011 and 2012.  However, since the Bush tax cuts are set to lapse after 2010, many taxpayers will want to report all conversion income next year while rates are still at their current levels.

A conversion that seems like a good idea at one point during the year will sometimes turn out to be the wrong decision due to unforeseen circumstances.  Fortunately, the IRS allows you to un-do a conversion up until the tax filing due date of that year’s return.  When would this come in handy?  One example is if market values decline substantially after you convert.  Tax is calculated based on the account’s value on the day of conversion, so if the assets are worth less than the amount on which you will need to pay taxes, a reversal is generally advised.  If you discover that your income for the year was higher than you anticipated, or if the conversion pushed you into a higher tax bracket, you also might want to consider a total or partial reversal.

Ultimately, no one knows for sure if taxes will be higher or lower in the future.  Having a variety of account types from which to draw funds - a taxable account, a traditional IRA, and a Roth - can act as a hedge against whatever happens down the road. Because everyone’s situation is different, always talk with your tax advisor before making a final decision on whether or not to convert to a Roth IRA.  We at TCI are happy to assist you in this decision process as well.