When To Convert Traditional IRA to a Roth IRA

Converting a regular IRA into a Roth IRA has several advantages for seasoned citizens, and it can benefit their heirs. A recent law makes it easier for some seasoned citizens to convert their IRAs. This is a good time of year to consider converting your regular IRA into a Roth IRA.

A conversion is allowed only when your modified adjusted gross income for the year is $100,000 or less. The modified AGI is AGI without any income caused by the Roth IRA conversion. The new law this year says that for those already over age 70½, modified AGI does not include the required minimum distribution from the IRA for the year. You still have to take the distribution and pay income taxes on it. But the distribution will not be included in modified AGI, so it won’t prevent you from doing a conversion.

The $100,000 ceiling applies whether you are single or a married couple filing jointly. If the combined income of a married couple exceeds $100,000, neither can do a conversion though each spouse separately might have modified AGI below $100,000. Married couples filing separately cannot convert a traditional IRA to a Roth IRA.

The price for converting to a Roth IRA is that the amount converted is treated as though it were distributed. The amount is included in gross income for the year, and income taxes must be paid. If you are under age 59½, however, the early distribution penalty is not incurred on a conversion. In effect, you pay the taxes now on the accumulated IRA in order to avoid all future income taxes.

There are several types of taxpayers who would benefit from a conversion despite the potentially high tax bill.

People with excess money in an IRA are ideal candidates for a conversion. They have enough sources of income and outside assets that they do not rely on the IRA to pay their living expenses. Instead, they view the IRA as an emergency savings account or something to pass on to their children.

As they pass age 70½, however, they must begin taking required minimum distributions from the IRA and pay income taxes on them. The distributions will grow as the owners get older. They will pay more taxes on income they do not need. In addition, their children who inherit the IRA will have to pay income taxes on the distributions they take from the IRAs.

The result is that the IRS gets one third or more of the IRA. The owners pay far more in taxes during their lifetimes than necessary. The children might get less than half of the IRA after estate and income taxes.

In such a situation, it makes a lot of sense to convert to a Roth IRA. Then, the required minimum distributions stop. The IRA balance continues to compound tax free. Future distributions to the owner are tax free, as are distributions taken by the heirs. When the Roth IRA is inherited, the new beneficiary must begin required minimum distributions. But those can be taken over the beneficiary’s life expectancy. If the beneficiary is young, the annual return likely exceeds the required minimum distribution, so the IRA continues to grow.

A conversion to a Roth IRA is best done when there are enough funds outside the IRA to pay the income taxes. That is because using the outside money to pay the taxes essentially is a way to increase contributions to the Roth IRA.

If you own a traditional IRA, the after-tax balance is its real value. In the top tax bracket, the after-tax balance can be two-thirds or less of the nominal balance. Using outside funds to pay the taxes restores the after-tax balance to its nominal value. Also, future income earned by the outside funds would have been taxable but become tax free when earned in the Roth IRA.

Tax rates also figure into the decision. If your heirs will be in a higher tax bracket than you are, then a conversion today makes sense. If you anticipate that the government will increase tax rates in the future, again converting at today’s income tax rates makes sense. But if your heirs are likely to be in a lower tax bracket than you are, or your tax rate is likely to drop in the future, it could make sense to maintain the traditional IRA or at least defer a conversion until the future.

If the main goal for your IRA is to maximize the amount available to your heirs or to use it as a reserve account, a conversion to a Roth IRA might make sense. Consider how the taxes on the conversion will be paid and the likely tax rate on future distributions.

There is an abundance of information to help you make this decision. The web site www.rothira.com probably is the most comprehensive and has links to Internet calculators. Another site with a lot of information is www.fairmark.com/rothira/index.htm. Of course, there is information in my book, The New Rules of Retirement, and in the Archive of our members’-only web site.