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Is a Roth IRA Conversion for you?

Should I convert my Traditional IRA to a Roth IRA? Unfortunately, there is no simple answer to this question and it must be determined on a case-by-case basis. It used to be that only taxpayers with incomes below $100,000 modified AGI were eligible to convert funds in a Traditional IRA into a Roth IRA. This kept high earners from enjoying the benefits of Roth IRAs altogether as they were not able to make contributions directly to a Roth IRA. But thanks to a change in the tax law beginning in 2010, all taxpayers, regardless of income are able to make the conversion. Still, there are a number of things to consider.

In a Traditional IRA, money normally goes in before tax and the pre-tax contributions plus earnings are taxed as ordinary income when withdrawn in retirement. In a Roth IRA, money is contributed on an after-tax basis and so is removed on a tax-free basis in retirement. The first and most important consideration is whether it will be beneficial to taxpayers to pay taxes today or in the future. If you are in a low tax bracket today and will probably be in a higher tax bracket in the future, then converting your Traditional IRA into a Roth IRA makes sense from a tax perspective. This would be the case for many young professionals early in their careers. In addition, tax rates are near an all-time low and if you believe, like we do, that rates are likely to rise over time, then consider a conversion. If tax rates do not change, there is no advantage to investing in a Roth IRA over a Traditional IRA from a tax standpoint.

Taxpayers who converted in 2010 can choose to pay taxes on the conversion over two years (you include half of the income in your 2011 and 2012 returns). For conersions in 2011 and beyond, taxes are due in the year of conversion. Keep in mind that if tax rates increase after 2010, so it may make sense to elect to pay all of the taxes in 2010 if you have the funds with which to pay the taxes.

The next consideration is your retirement nest egg. Do you have enough socked away for retirement? Is it likely that you will be able to live in retirement without using the funds in your Traditional IRA? Do you have a long life expectancy and plan to work well into your golden years? If you answered yes to any of these questions, then the case for converting to a Roth improves. With a Traditional IRA, once the taxpayer reaches the age of 70½, annual withdrawals known as Required Minimum Distributions (RMDs) must begin. This is frustrating for those taxpayers who have other sources of income and could survive without pulling money out of their IRAs annually and paying the requisite taxes.

The fourth thing to consider is how much you'd like to put away for retirement. The people eligible to contribute directly to a Roth IRA in 2010 are those taxpayers earning less than $120,000 if single or $176,000 if married filing jointly. This leaves high wage earners ineligible to contribute directly to a Roth IRA. However, anyone is eligible to contribute to a Traditional IRA on a non-deductible basis and then convert those after-tax funds to a Roth IRA. In this case, only the earnings are taxable. One new strategy employed by high-income taxpayers this year is to make contributions to their Traditional IRAs and immediately convert the funds to Roth IRAs, avoiding any taxes since the money has not had a chance to grow.

A final consideration in the decision of whether or not to convert to a Roth IRA is for estate planning purposes. Just as owners of Roth IRAs are not required to withdraw funds during their lifetimes, spouses who inherit Roth IRAs from a decedent can elect to treat the Roth IRA as their own and are not required to touch the funds either. With an inherited Traditional IRA, non-spouse heirs are required to withdraw money and pay taxes over their life expectancy. While those who inherit a Roth IRA must take RMDs as well, the distributions may still be tax-free. This could help your cash-poor heirs.

As you can see there are a number of complex factors to consider before converting a Traditional IRA to a Roth IRA. The main question is whether you are subject to lower tax rates today than in the future. Contact Hartman Financial Planning and/or your tax professional to help you make the decision on whether or not to convert.