Weighing the Pros and Cons of IRA Conversions

Forget all you’ve heard about converting traditional IRAs into Roth IRAs. There are too many rules of thumb, shortcuts and plain misinformation floating around. Also, circumstances change. You might have evaluated the conversion option a few years ago and reached a decision. You should re-evaluate that decision regularly, because important factors might be different now. Let’s take a fresh look at the strategy.

A Roth IRA can provide significant advantages, but the price is you don’t receive the up-front tax benefits of a traditional IRA. Contributions to a Roth IRA aren’t deductible; you contribute after-tax dollars. When a traditional IRA is converted to a Roth IRA, you pay taxes on the converted amount; it is included in gross income as though it were distributed to you.

You know that distributions from a Roth IRA are tax free. Here are the other advantages you might gain from a Roth IRA.

• No required minimum distributions (RMDs) after age 70½. This is a significant advantage to those who have other sources of income and cash flow. They often are subject to the IRA Waterfall. That’s when RMDs accelerate over time and require much higher distributions than the IRA owner needs, triggering higher income taxes.
• Better tax-bracket management. You can’t control some sources of income, but you control how much to withdraw from a Roth IRA. That flexibility gives you more control over your tax bracket. To keep from rising into a higher tax bracket, you can take Roth IRA Distributions instead of selling investments or taking additional traditional IRA distributions. In years when a higher tax bracket isn’t a risk, you can take more from other accounts and save the Roth IRA for other years.

• Freedom from stealth taxes. Higher Medicare premiums, taxes on Social Security benefits, reduced itemized deductions and other stealth taxes hit older Americans more than others. These taxes are triggered by higher adjusted gross income (AGI). Since Roth IRA distributions aren’t included in AGI and a Roth doesn’t have RMDs, converting all or part of a traditional IRA to a Roth IRA can help you avoid stealth taxes, especially after age 70½ when the RMDs on a traditional IRA kick in.

• A tax-free legacy. Often the best use of an IRA conversion is that it enables you essentially to pay income taxes for heirs and leave them the tax-free Roth IRA instead of a taxable traditional IRA. A Roth IRA is a valuable inheritance for a child or grandchild.

Despite the advantages, an IRA conversion is not for everyone. A number of factors determine whether a conversion is a good idea, and the factors might change from one year to the next. Here are the key factors to examine to decide if an IRA conversion is a good strategy for you:

Is your tax rate likely to change? Future tax rates can be tough to forecast, but any changes that seem likely should influence your decision. If you’re confidant you’ll be in a lower tax bracket in the future than today, a conversion is less likely to make sense. A conversion is more likely to pay off when you’ll be in the same or a higher bracket in the future.

An optimum time to consider a conversion is a year when your taxable income takes a sudden dip. That could occur because of a job loss, reduced hours, the first year of retirement, or a sudden increase in deductions (such as from large medical expenses).

When evaluating future taxes, don’t forget to consider the stealth taxes that could be triggered by RMDs if you retain a traditional IRA. Also, consider possible future tax increases by Congress.

Don’t forget state income taxes. This usually is not a major factor, but it could be a tipping point when you’re in a high-tax state, expect state income taxes to rise, or your state doesn’t exempt Roth IRA distributions from income taxes.

Can you let the Roth IRA compound? Compounded tax-free returns over time are needed to make up for paying taxes early, so it usually doesn’t doesn’t make sense to convert if you plan to spend the account quickly. My research over the years shows a converted IRA needs at least seven years of compounding at an 8% annual return to make up for the taxes. A longer compounding period is needed at a lower rate of return.

How will you pay the conversion taxes? You can pay the conversion taxes by taking some money from the IRA, but that increases the cost of the conversion. It’s better to pay the taxes from other sources of cash.

What will be the IRA’s rate of return? Th Roth IRA is more valuable at higher rates of return, because you’re generating more future

tax-free cash in return for paying the taxes early. The lower the return, the longer it takes to make up for paying the taxes early. Someone who invests very conservatively and earns a low return might not benefit from a conversion or will take longer to see the benefits.

How significant are other income and assets? The best case for a conversion is someone who has signifi ant income and assets outside the IRA and doesn’t rely on the IRA as a main support of his or her standard of living. When the IRA is an emergency savings vehicle and something to be left to heirs, the case for conversion is strongest. The conversion helps the IRA owner avoid required minimum distributions. That reduces current income taxes and preserves more of the IRA for heirs. The conversion becomes an estate planning tool and can be very effective at increasing the after-tax wealth of heirs. A conversion can be a good idea in many other cases, but that is the strongest case.

How has the IRA’s value changed? Th taxes are computed on the amount converted on the day of the conversion. That means the ideal time to convert an IRA is after the balance has taken a tumble, such as during a bear market or correction. After a market decline, a conversion that didn’t make sense a few months earlier suddenly could make sense, especially if you conclude the decline is temporary. You’ll be paying taxes at a discount and avoiding taxes on those future gains when the value recovers.

Those are a lot of factors to consider, and it takes careful analysis to make the right choice. Don’t try to use a rule of thumb or make an intuitive decision. Instead, you should use one or more of the many calculators that are available to help make the decision. Many financial planners and estate planners also have access to conversion calculators marketed to professionals. There are many free calculators on the web, but most do not let you change all the variables. Good ones are at www.bankrate.com, www.rothretirement.com and www.dinkytown com. Financial professionals use more expensive and robust calculators, such as the one at www.brentmark.com. Some people construct their own computer spreadsheets.

I built a calculator using an Excel spreadsheet that allows most variables to be changed. It’s available for $20. Details are in the Bob’s Library tab on the web site at www.RetirementWatch.com.

I recommend using more than one calculator, so you can see how the results may vary under different methods and when not allnthe variables can be changed. There are three additional points to keep in mind.

A 401(k) account can be converted to a Roth 401(k) account, if the employer plan allows. Tax law was changed a few years ago to permit this. Many employers are adopting Roth 401(k)s and conversion privileges.

Converting an IRA isn’t an all-or-nothing or one-time decision. You can convert a portion of an IRA one year. Some people schedule a series of annual conversions. They convert an amount that avoids pushing them into the next highest tax bracket.

A conversion can be changed. You have until Oct. 15 of the year following the conversion to change back to a Roth IRA (known as a re-characterization) without penalty.