Reviewing the IRA Conversion Decision

We’re in the last months of the year of the IRA conversion opportunity. Many tax-payers are converting their traditional IRAs and 401(k) accounts into Roth IRAs. Others still are considering the move. In our visits over the last couple of years we covered all the key issues and details. In this visit we review the key factors to consider.  You can find the past articles with more details in the Archive on the members’ web site.

Even if you already converted a retirement account into a Roth IRA, you need to review these factors. You have until Oct. 15, 2011, to recharacterize (reverse) a conversion made in 2010, assuming you file your 2010 tax return on time. When circumstances changed or an assumption or analysis was wrong, a recharacterization can be a good idea.

? Key Factors. Four key factors determine whether a conversion will increase after-tax wealth.

Future tax rates. When your tax rates will be higher or the same in the future, paying taxes today via an IRA conversion could make sense. If you anticipate your tax rates being lower when money is withdrawn from the IRA, a conversion may not pay off.

Expected return. The higher the expected investment return, the more profitable a conversion is likely to be.

Accumulation period. The bulk of the account needs to be left in the Roth IRA to compound for years, again to make up for paying taxes early. My studies show the breakeven point for many investors is about 10 years. If you’ll be withdrawing significant amounts before then, a conversion probably won’t pay off. A low rate of return leads to a longer breakeven point.

Source of taxes. You want to pay the taxes from a non-IRA account so all of the IRA remains invested to compound and generate future tax-free income. When you need to withdraw money from the IRA to pay the conversion taxes, a conversion is less likely to increase after-tax wealth.

? Not all or nothing. You can convert any portion of an IRA. Some people compute the amount of taxes they’re willing to pay or how the conversion will affect the rest of their taxes (see below), and convert the appropriate amount. You can plan to convert an IRA over several years or all in one year. When you own more than one IRA you can convert all of them, one of them, or a portion of one or all of them.

? Take Your RMD. When you are taking required minimum distributions from a traditional IRA you plan to convert, you have to take the RMD for the year of the conversion.

? Other tax effects. When a traditional IRA is converted to a Roth IRA, the converted amount is included in gross income. The higher gross income could increase taxes by changing other parts of your return. More of your Social Security benefits could be taxed. Itemized deductions and personal and dependent exemptions could be phased out. The alternative minimum tax could be triggered.

Because of these effects, some people limit the amount they convert each year, and they plan to convert their IRAs over time so the increase in gross income is spread out.

Keep in mind that the effect is only for the year of the conversion. In future years, the conversion can have the opposite effect. Distributions from the Roth IRA won’t be included in gross income. Compared to distributions from a traditional IRA, you’re less likely to pay taxes on Social Security benefits, trigger the AMT, or lose itemized deductions or exemptions.

When you are a parent of high school or college aid children, the conversion also could reduce eligibility for financial aid.

? Medicare Premiums. Medicare Part B premiums are adjusted for income, with a two-year lag. If you’ll be a Medicare beneficiary in two years, a conversion in 2010 could increase your premiums. The effect will be for only the year of the conversion. See the article in this issue for more details.

? Deferral Option. For 2010 conversions only, you can elect to defer the taxes. You can pay the taxes in 2010 or include half the converted amount in gross income in 2011 and half in 2012. When you choose deferral, you’ll pay the taxes at whatever rates apply to you in those years.

? Using Multiple Roths. Instead of converting an entire traditional IRA into one Roth IRA, you can convert each asset into a separate Roth. That means assets that decline in value after the conversion can be recharacterized, and the others can be left as Roth IRAs. Eventually you can consolidate them all in one Roth IRA.

? Beneficiary Forms. Don’t forget to complete beneficiary designations for the Roth IRA. It is a new account, and your beneficiaries from the traditional IRA likely won’t carry over.

? After-Tax Money. When nondeductible contributions are in a traditional IRA or 401(k), they aren’t taxed when converted to a Roth. When less than the entire IRA is converted, however, a pro rata portion of the converted amount is tax free.

? Five-Year Rule. Distributions of income and gains from a Roth IRA aren’t taxable until five years have passed. There’s a lot of confusion about the five-year rule. If you’re thinking of taking money out of the converted IRA after less than five years and want to know the tax treatment, take a look at the discussion in our May 2010 issue or in the Archive on the members’ section of the web site. Don’t forget there are two different five-year rules: one for income taxation of distributions and one for the 10% penalty on early distributions.

When you want to convert a traditional account to a Roth account, don’t wait until the end of the year. Your IRA custodian likely will be inundated with many transaction requests in December. Wait too long to put in your order, and it might not be processed by Dec. 31. Also, you need to follow up. Custodians make mistakes. Be sure to confirm the right amount was transferred and that it was put in a Roth IRA and not some other type of account.

RW November 2010.