Several key factors determine whether it is a good idea to convert a traditional IRA to a Roth IRA. We discussed these in recent visits, and they include the difference between your tax rates now and in the future, how you pay the taxes on the conversion, and the rate of return on your IRA.
There are other factors to consider. These issues don’t apply to everyone considering a conversion, but for those to whom they apply these are significant factors and can influence the decision.
Social Security benefits. Your Social Security benefits might be subject to income taxes, depending on your modified adjusted gross income (MAGI) when the benefits are received.
Up to 50% of benefits are taxed when MAGI exceeds $32,000 for married couples filing jointly and $25,000 for singles. Up to 85% of benefits are taxed when MAGI exceeds $44,000 for married couples and $34,000 for singles.
Distributions from traditional IRAs are included in MAGI, but distributions from Roth IRAs are not. When your SS benefits are taxed, your marginal tax rate rises. Converting a traditional IRA to a Roth IRA could save you taxes on the benefits every year for life, amounting to thousands of dollars of additional taxes saved.
Loss of tax benefits. Itemized deductions, personal exemptions, and some other tax benefits are reduced or eliminated at higher income levels. Traditional IRA distributions, especially required minimum distributions, can trigger these benefit reductions. When they do, that is another sharp increase in your marginal tax rate. Roth IRA distributions don’t have this effect. Converting your IRA can save these additional taxes when you are in or near the income levels at which these benefits are reduced.
There is a potential flip side to tax deductions. Since Roth IRA distributions are not included in gross income, your income is less after a conversion. Suppose you continue itemizing deductions for charitable contributions, mortgage interest, real estate taxes, and medical expenses. At the higher tax bracket you’d be in when distributions are taken from a traditional IRA, the tax deduction is more valuable. After a conversion, however, you are likely to be in a lower tax bracket. You’ll receive a lower tax benefit from the deductions, and the government will pick up a lower share of the cost.
Alternative minimum tax. Converting a large amount of an IRA could push you into the AMT, denying the benefit of some tax breaks and increasing your overall tax burden. Before deciding how much of an IRA to convert, estimate what your tax will be and don’t forget to compute both the regular tax and AMT.
Medicare premiums. Premiums for Medicare Part B now are “means-tested,” meaning that higher income beneficiaries pay higher premiums for the same coverage. Your income for two years earlier determines your current year’s premiums. Your Roth IRA conversion will increase one year’s income. If you will be 65 or older two years later and receiving Medicare Part B, then your premiums will be higher for one year. You may be able to reduce the premiums by filing an appeal and arguing that the income reported for the year is not representative of your income and your current year’s income should be used instead.
Charitable gifts. When you make charitable gifts from your estate, it is better to make them from an IRA instead of other assets. Your heirs are better off inheriting non-IRA assets when they can. When you convert to a Roth IRA, however, there is no benefit to making the charitable gifts from the IRA. I don’t think that overrides the benefits of receiving tax-free income from the Roth IRA, but it does reduce the options for making charitable contributions from your estate.
Tax changes. One argument against Roth IRAs from their beginning is that Congress can take away what it has given. Social Security benefits used to be tax-free. Now, they are partially taxed above certain income levels, and the number of people paying those taxes increases each year. There’s nothing to keep a future Congress from imposing taxes on some or all Roth IRA benefits once investors have channeled a few billion dollars into Roth IRAs. On the other hand, Congress may keep increasing income tax rates on regular taxable accounts and not touch Roth IRAs. You have to consider the potential for tax changes before deciding whether to convert and how much to convert.
Tax diversification. Tax laws change, but we can’t predict how they will change. Instead of trying to forecast the impossible, diversify your accounts. Have some money in taxable accounts, tax-deferred accounts (traditional IRAs, 401(k)s, and deferred annuities), and Roth IRAs. That way you won’t be betting your tax future on one outcome. With diversification you aren’t likely to have the lowest tax result under any scenario, but you also won’t be stuck with the worst tax result in any scenario.
Some of these issues are “little picture” issues instead of big picture issues. Others are speculative, such as future tax changes. For most people they won’t change the decision of whether or not to convert. For others, they are the tipping point that will decide whether to convert or how much to convert.
March 2010. RW