Converting a traditional IRA to a Roth IRA has been a valuable tool to consider since the Roth was created in 1997. There are two reasons why a conversion is worth far more consideration now than in the past.
First, a brief review of the basics. A Roth IRA has “back-ended tax benefits.” There are no deductions for contributions. Like a traditional IRA, earnings are not taxed while they remain in the account. The big benefit is that qualified distributions from the Roth IRA are tax free. A qualified distribution is one that occurs on the later of when the owner turned age 59½ and five years after the owner opened any Roth IRA. The distributions are tax free whether made to the original owner or to a beneficiary who inherits the Roth IRA.
Another benefit of the Roth IRA is there are no required minimum distributions imposed on the owner. The owner does not have to take money out of the IRA unless he needs it. The Roth can compound undisturbed and be left to the next generation if desired. Beneficiaries are required to take minimum distributions based on their life expectancies.
There are a few other benefits of the Roth IRA. Distributions are not included in gross income when determining the amount of Social Security benefits to be taxed. In addition, when nonqualified distributions are taken, contributions are considered to be withdrawn before accumulated income and gains. That means money can be withdrawn tax free if needed, and no taxes are due until all the contributions have been withdrawn.
A Roth IRA can provide higher retirement benefits than a traditional IRA if the tax-free compounding is allowed to work for years. With the traditional IRA, the price of deducting contributions (“front loaded tax benefits”) is distributions are taxed as ordinary income. That means long-term capital gains are converted into ordinary income.
Investors with traditional IRAs may convert them to Roth IRAs if adjusted gross income is no more than $100,000. The AGI limit applies regardless of filing status. A married couple filing jointly with a joint AGI above $100,000 cannot convert, even if each would be eligible separately to convert. The AGI limit for marrieds filing separately is $0, so couples cannot become eligible by filing separate returns. Any required minimum distribution for the year does not count toward the $100,000 limit.
The price for converting a traditional IRA to a Roth IRA is to treat the converted amount as though it had been distributed. The amount is included in gross income.
We discussed conversions in some detail in past visits, and those discussions are in the Archive on the web site. Our research points to several conclusions about converting a traditional IRA to a Roth IRA:
A conversion can make sense if the Roth IRA will be allowed to compound for years before distributions begin. If a 6% rate of return is expected, it takes about 10 years of compounding to make up for paying the taxes.
The income taxes should be paid from separate assets instead of from the IRA. You want the full IRA balance to benefit from the tax-deferred compounding and eventual tax-free distributions. Otherwise it takes learn for the conversion to pay off.
The higher the rate of return of Roth IRA, the faster you reach the pay-off from the conversion. You don’t want to convert a traditional IRA to a Roth IRA and invest the Roth IRA in certificates of deposit or short-term bonds.
All or part of an IRA can be converted, and there is no limit to the dollar amount that can be converted in a year. If you own more than one IRA, they can be converted in any combination you want: all of one, portions of more than one, or even all of each of them.
A nice feature of the Roth IRA conversion is that you get to reverse it if it turned out to be a bad idea. We will discuss that shortly.
One of the factors that should make a conversion to Roth IRA worth serious consideration is the bear market in investment assets across the board.
Remember the conversion tax is imposed by including the converted amount in gross income. The lower the value of the IRA on the date of conversion, the lower the tax will be. The bear market has decreased the value of many IRAs to their lowest levels in years. You can convert a traditional IRA to a Roth IRA at a much lower cost than in the past.
The benefit of converting a Roth IRA at a low level is that the future appreciation and income will be tax free. As the IRA recovers from the bear market, the value that would have been taxed as ordinary income before the bear market will be tax free after the conversion and recovery.
Converting to a Roth IRA can be an important move in restoring your retirement fund. Take the example of Max Profits, who had a balance of $500,000 in his IRA at its peak. Recently it was worth $250,000. At the peak, Max’s IRA had an after-tax value of only $325,000 in the 35% tax bracket. Converting to a Roth now would cost $87,500 in taxes (compared to $175,000 at the peak). After the Roth IRA is converted and returns to its future value, the after-tax value is $500,000.
The trade off in a conversion is that you lose the money used to pay the taxes and future after-tax earnings on that money. As I said, my analysis over the years has shown that someone who expects to earn a return of 6% needs about 10 years of compounding to break even. But the forecast changes based on a number of key assumptions, including your current and future tax rates, the rates of return on the IRA and non-IRA assets, and the amount of time before distributions begin.
The calculations can be complex, and there are a number of web sites with calculators to help you. The quality of the calculators differs, because not all allow you to vary each of the assumptions. Most mutual funds and brokers have calculators on their sites. A good calculator also can be found at www.rothira.com. A few other calculators with no ties to financial products or services are at www.datachimp.com, www.voli-tion.com, www.dinkytown.com, and www.cust-omcalculators.com. (Ignore the hyphens.) Financial planners of course can do calculations for you.
Another reason to consider converting now is that income taxes are likely to rise in the future. Most political observers expect taxes to increase, and the President-elect and the majority in Congress advocated higher taxes on at least some taxpayers. If you have enough time to compound returns to make up for paying taxes early, why not pay taxes at today’s lower rates? Doing so shortens the pay off period.
The conversion to a Roth IRA essentially is risk free, because if circumstances change or there is a mistake in your assumptions, you can reverse the conversion, known as a recharacterization.
The two most common reasons to reverse a conversion are that the portfolio continued to decline in value and that AGI income exceeded the $100,000 limit. Some people also recharacterize when the conversion pushes them into a higher tax bracket or when they no longer have cash to pay the conversion taxes.
A recharacterization can be done any time before the due date of the tax return for the year of the conversion, including extensions. The extension date can be used for the recharacterization even if the taxpayer filed the return by April 15. For example, if an IRA is converted in 2009, the recharacterization can occur any time up to Oct. 15, 2010, regardless of when the 2009 return is filed.
After a recharacterization, it is possible to convert to a Roth IRA again. The second conversion cannot occur in the same calendar year as the first. The second conversion also cannot occur within 30 days after the recharacterization.
Higher income individuals will have a chance to convert their traditional IRAs to Roth IRAs in 2010 and later years, unless the law changes. All taxpayers who convert in 2010 will have the opportunity to defer taxes on the conversion, again unless the law changes. Details about the opportunities in 2010 were in our March 2008 visit, which is available in the web site Archive.
IRA owners with AGI of $100,000 or less must consider whether to convert their IRAs in 2009 or 2010. The benefit of a conversion in 2010 would be the ability to defer taxes on the conversion interest free. The larger benefit, however, is likely to come from converting the IRA at a low value. Watch your portfolio. If it remains stagnant or in a trading range through 2009 as I expect, waiting until 2010 to convert is worthwhile. But if a new bull market seems underway, convert before it goes too far. The tax savings from a low conversion value are more valuable than deferral in 2010 at a higher value.
More details about conversions to Roth IRAs are in my book, The New Rules of Retirement, and are in the web site Archive under IRA Watch.