Financial Planning Blog

You've maybe heard about the opportunities opening up in 2010 for converting traditional IRAs to Roth IRAs. You might be wondering if this is something you should be paying attention to. In this post, we'll briefly look at what the changes are, and what the key considerations are in deciding whether a Roth conversion is right for you.

First, we'll assume you know the differences between a traditional IRA and a Roth IRA. If not, read the first part of this article from Charles Schwab.

Many of you may not have paid much attention to Roth IRAs because all of your retirement savings have been funneled into your company 401K or 403B plan. Others may have wished you could take advantage of Roth IRAs, but have been unable to because you earn too much money. In 2009, that means over $105k for a single person, or over $166K for married filing jointly. (All things considered, this is one of the better financial problems to have, so don't let people hear you complain.) Unfortunately, there are no changes in 2010 regarding who can contribute to a Roth.

What is changing in 2010 are the rules of who can convert traditional IRAs to Roth IRAs. Prior to 2010, only people making less than $100K (modified adjusted gross income) could convert existing traditional IRAs to a Roth IRA. Although this is a relatively simple process, the conversion entails paying taxes on the conversion--a big obstacle (emotionally if not financially) for many. In 2010, the $100K income limit is eliminated, opening the door for many who were previously ineligible to now convert substantial IRA assets into Roth IRAs.

Now that everyone with a traditional (or roll-over) IRA has an opportunity to convert those assets to a Roth IRA, who should consider doing so?

• If you think you will be in the same or higher tax bracket during retirement, conversion may make sense. (For an explanation of this, see the example associated with Figure 1 in this TIAA-CREF Institute article.) Of course, none of us can be sure of what future tax rates will be, but you have to admit that there is significant risk of increasing tax rates necessitated by the current high federal deficits. A Roth conversion may be part of a strategy of "tax diversification", allowing you to better manage your income tax liabilities in retirement.
• However, you need to be able to pay the income taxes on the conversion out-of-pocket (i.e. not from assets you are converting). If you use IRA assets to pay for the taxes, you pretty much lose the benefit of the conversion. (Plus, if you are under 59.5, the money you take from your IRA to pay the taxes are an early distribution, and you will likely incur an additional 10% penalty on top of federal and state income taxes. Ouch!)
• Generally speaking, you shouldn't need the converted money for at least five years. First, the benefit to the conversion is greater the longer the money is left to grow. Second, there is a five year rule--a waiting period before taking distributions from the converted assets. This is made even more confusing, because there is a separate and different five year rule that applies to normal (i.e. not from converted assets) Roth distributions. See here and here for more details.
• If you have a taxable estate, or simply want to maximize the benefits to those who stand to inherit your IRA, conversion to a Roth has real advantages. By converting assets and paying taxes now, there are potential estate tax savings and income tax savings for the heirs. (Of course, the whole estate tax picture is currently up in the air, so planning is difficult.) Since an inherited Roth IRA will not be taxed as your heirs make required distributions, it is worth much more than the same assets within an inherited traditional IRA.

Although the increased opportunity to take advantage of Roth conversions is for 2010 and beyond, there is a potential added benefit for making the conversion in 2010. For conversions next year only, taxpayers will have the option of either paying the taxes on the conversion in 2010, or delaying and splitting the tax liability between 2011 and 2012. Although this may ease the cash flow burden of a conversion next year, you need to consider whether your expected marginal tax rates could potentially be higher in the later years than in 2010. (If you expect your tax rates to be lower in those years, it makes the decision to delay the paying the taxes pretty easy.)

As you can see, the decision process for converting to a Roth is not an easy one, and the advantages may not seem obvious. Take your time to consider whether it is in your best long term interest, and seek competent counsel as necessary.