Should you be considering converting your traditional IRA to a Roth IRA
Should consider converting your traditional IRA to a Roth IRA??
Essentially the concept of a Roth IRA is that you pay taxes on the “acorn” (the initial contribution) instead of the “oak tree” (the potentially large amount in the Roth IRA after many years of tax deferred accumulation). Besides allowing tax-free and penalty-free withdrawals of contributions, the Roth IRA enables most savers to amass a greater nest egg because withdrawals from earnings during retirement are tax-free (as long as you are over 59 1/2 and have had the account for at least five years). The near term trade off is that you will need to pay taxes on the amount of the conversion. How can you determine if this strategy is right for you??? [read full article]
Historically, income limits have taken this option off the table for many taxpayers. In 2010 however, the $100,000 MAGI limit for converting assets from a Traditional IRA to a Roth IRA is eliminated. Although a person who exceeds the MAGI limit will still not be able to contribute to a Roth IRA, in 2010 and future years anyone may convert assets in a Traditional IRA to a Roth IRA, no matter what their income level.
Paying taxes on conversion
The amount converted is generally added to your taxable income for the year of conversion to extent it exceeds any non-deductible contributions in the account. For conversions in the year 2010 only, however, the person converting has the choice of paying 50% of the taxes on the conversion in 2011 and the other 50% in 2012. You have 3 years to pay taxes on Roth conversions done in 2010!
Retirement planning considerations
Generally, the older you are, the less sense it makes to convert a traditional IRA to a Roth. You'll have less time to make up for what you lost in taxes on the conversion.
Estate planning tool
One case in which it makes sense for an older traditional IRA holder to transfer funds to a Roth IRA is when he or she is planning to leave the money to heirs. There are two reasons. First, Roths require no minimum withdrawals during the life of the IRA owner. If the surviving spouse inherits the Roth account, he or she need not take any minimum withdrawals either. With a regular IRA, you must begin taking taxable withdrawals from that account no later than the year after you turn 70 1/2. So you lose out on the chance for that money to continue to compound without paying taxes. That can mean a lot less money for your heirs. Secondly, conversion to a Roth will reduce your taxable estate by the amount of income tax you pay to convert. This can reduce estate taxes for your heirs.
Income tax rates, now and in the future
One case in which converting from a regular tax-deductible IRA to a Roth IRA does not make sense is when you expect to drop into a much lower income tax bracket after you retire (say, from 25% to 15%). Why? You will have to pay income tax on the conversion at your current high rate. Instead, let the money compound in your regular IRA and pay taxes at your lower rate in retirement. However, if your tax rate is only expected to drop a few points after retirement (say, from 28% to 25%), conversion is probably still the a good move.
Market performance impact
Another useful strategy is to separate your converted investments into several different Roth accounts based on asset class, and recharacterize the IRAs that do not perform well. So you can convert, see how the market performs, and potentially “un-do” a conversion if a particular investment pool does not go your way. The deadline for recharacterizing a 2010 Roth conversion is October 15, 2011. If a recharacterization is not done by that date, the taxpayer will be locked into any tax liability from the conversion, including reporting income ratably over 2011 and 2012 if applicable.
Like any investment or tax saving strategy, you should discuss this with your financial planner. If you would like to discuss your specific financial situation to see if a conversion will makes sense for you, do not hesitate to contact me directly.
John A. Davidson, CPA, CFP®
Return to News Home
Essentially the concept of a Roth IRA is that you pay taxes on the “acorn” (the initial contribution) instead of the “oak tree” (the potentially large amount in the Roth IRA after many years of tax deferred accumulation). Besides allowing tax-free and penalty-free withdrawals of contributions, the Roth IRA enables most savers to amass a greater nest egg because withdrawals from earnings during retirement are tax-free (as long as you are over 59 1/2 and have had the account for at least five years). The near term trade off is that you will need to pay taxes on the amount of the conversion. How can you determine if this strategy is right for you??? [read full article]
Historically, income limits have taken this option off the table for many taxpayers. In 2010 however, the $100,000 MAGI limit for converting assets from a Traditional IRA to a Roth IRA is eliminated. Although a person who exceeds the MAGI limit will still not be able to contribute to a Roth IRA, in 2010 and future years anyone may convert assets in a Traditional IRA to a Roth IRA, no matter what their income level.
Paying taxes on conversion
The amount converted is generally added to your taxable income for the year of conversion to extent it exceeds any non-deductible contributions in the account. For conversions in the year 2010 only, however, the person converting has the choice of paying 50% of the taxes on the conversion in 2011 and the other 50% in 2012. You have 3 years to pay taxes on Roth conversions done in 2010!
Retirement planning considerations
Generally, the older you are, the less sense it makes to convert a traditional IRA to a Roth. You'll have less time to make up for what you lost in taxes on the conversion.
Estate planning tool
One case in which it makes sense for an older traditional IRA holder to transfer funds to a Roth IRA is when he or she is planning to leave the money to heirs. There are two reasons. First, Roths require no minimum withdrawals during the life of the IRA owner. If the surviving spouse inherits the Roth account, he or she need not take any minimum withdrawals either. With a regular IRA, you must begin taking taxable withdrawals from that account no later than the year after you turn 70 1/2. So you lose out on the chance for that money to continue to compound without paying taxes. That can mean a lot less money for your heirs. Secondly, conversion to a Roth will reduce your taxable estate by the amount of income tax you pay to convert. This can reduce estate taxes for your heirs.
Income tax rates, now and in the future
One case in which converting from a regular tax-deductible IRA to a Roth IRA does not make sense is when you expect to drop into a much lower income tax bracket after you retire (say, from 25% to 15%). Why? You will have to pay income tax on the conversion at your current high rate. Instead, let the money compound in your regular IRA and pay taxes at your lower rate in retirement. However, if your tax rate is only expected to drop a few points after retirement (say, from 28% to 25%), conversion is probably still the a good move.
Market performance impact
Another useful strategy is to separate your converted investments into several different Roth accounts based on asset class, and recharacterize the IRAs that do not perform well. So you can convert, see how the market performs, and potentially “un-do” a conversion if a particular investment pool does not go your way. The deadline for recharacterizing a 2010 Roth conversion is October 15, 2011. If a recharacterization is not done by that date, the taxpayer will be locked into any tax liability from the conversion, including reporting income ratably over 2011 and 2012 if applicable.
Like any investment or tax saving strategy, you should discuss this with your financial planner. If you would like to discuss your specific financial situation to see if a conversion will makes sense for you, do not hesitate to contact me directly.
John A. Davidson, CPA, CFP®
Return to News Home