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Should You Do a Roth Conversion?

This is the final article is a series on Roth IRA conversions.

We’ve been talking about Roth IRA conversions [1] all week. To recap, the 2010 Roth conversion rules [2] mark the first year that there is no income limit for Roth IRA conversion eligibility. Because of that, many people have access to a Roth IRA for the first time.

While you shouldn’t rush [3] into a Roth IRA conversion, there are many instances where a conversion will leave you in a better financial situation over the long term. When deciding whether a Roth conversion is right for you, there are two main things to consider: the effect on your finances during the year of Roth conversion, and the effect at retirement.

Consider a Roth Conversion if:

  • You believe you will be in a higher tax bracket during retirement. When you convert, the conversion amount will count as income and you will pay taxes on pre-tax contributions plus growth using today’s tax brackets [4]. You’ll get hit with a larger bill up front because you’re paying on all of it, but if you anticipate a rise in overall tax rates or your own personal bracket, you’ll pay less per dollar of withdrawals by converting today. Plus, paying taxes now and converting means you never have to pay on future earnings. However remember that many people find themselves in lower brackets come retirement age.
  • You cannot contribute new funds to a Roth IRA. If you are over the Roth IRA contribution limits [5], you can now contribute to a traditional IRA and convert each year – but you never know if the rules will change. Converting what you have now is your best chance to take advantage of the tax breaks offered by a Roth.
  • You are over 70 ½ and do not need access to your rollover-eligible funds. IRA account owners must take taxable minimum distributions [6] each year after attaining the age of 70 ½, but Roth IRAs do not have the same requirement. Roth funds can sit in the account untouched until the owner’s death. If you do not need the income in future years, you can preserve the funds for your heirs by paying taxes on the rollover and letting your funds continue to grow tax free. If you believe your children or grandchildren will be in a lower tax bracket after your death, you may want to skip conversion and let them pay (lower) taxes later instead.
  • Your IRA contributions have dropped in value. If you convert funds that have dropped in value, you only have to pay taxes on what you actually convert – even if it’s less than you originally contribute. If we continue to experience a rebound from the stock market lows, you’ll enjoy tax-free growth after conversion. And if by chance your funds continue to drop, you can do a recharacterization [7] back to a traditional IRA and get some of your tax payment back.

Hold Off or Only do a Partial Roth Conversion if:

  • You would tap the conversion amount to pay taxes. In order for a conversion to make sense at all, you must be able to pay the taxes on the conversion amount from outside your retirement funds. Using funds to pay the tax bill lowers the amount of money you have available to grow tax free and withdraw in retirement. Plus, you may face a penalty [8] if you’re under 59 ½. If you want to convert only your nondeductible IRA contributions, you can do so using a special Roth IRA conversion strategy [9].
  • Your conversion amount would place you in a higher tax bracket. If doing a full conversion will place you in a new tax bracket, you may wish to convert over a few years. For example, say you have $10,000 before moving into the 28% bracket, and you have $25,000 to convert. If you convert all now, you’ll pay 25% on $10,000 and 28% on the remaining $15,000. Alternatively, you can convert $10,000 this year (at 25%) and another $10,000 next year, also at 25%. Remember that the special provisions for spreading out your tax bill only apply to conversions done in 2010.
  • You expect to be in a lower tax bracket at retirement. If you expect to be in a much lower tax bracket at retirement, it may not make sense to convert now. The final decision depends on how many years you have until retirement and how much growth you expect. If you are relatively young and expect high appreciation, it might make sense to pay a high tax rate on a lower amount. But if you have only a few years until retirement, chances are the math for conversion doesn’t quite work out.
  • You want to avoid increased taxation of your Social Security Benefits and/or Medicare premiums. IRA conversions basically count as income for tax purposes – and for purposes of calculating Medicare premiums and the taxation of your Social Security Benefits. Of course these adjustments will only matter for one year, so this shouldn’t be a huge factor in your decision.

Additional Resources

Converting to a Roth IRA is a good idea for many people, but figuring out all the possibilities and implications can be an intense process! Jeff over at Good Financial Cents [10] has an excellent post [11] detailing the calculations, considerations and tax consequences of a few sample rollovers. He pays attention to some intricate details that are a big help to anyone seriously considering a rollover. You can also check out this roundup of conversion calculators [12] over at ConsumerBoomer. If you’re over 70, read about some special considerations over at Vanguard [13]. And of course, don’t forget that it’s always a good idea to check with a tax professional [14] and/or financial planner [15] to make sure that your plan is the absolute best for your personal circumstances.