Questions to Ask Before Converting to a Roth IRA
Frequently Asked Questions
1. Is it possible? Assets that are eligible to be converted include Traditional IRAs, assets in a 401k or 403b plan from a former employer, a SEP or a SIMPLE. Generally, you can’t convert assets held in a 401k or 403b with your current employer, although you have to ask your employer to be sure. You can’t convert inherited IRAs. If you don’t have any assets that are eligible to be converted, then it’s not possible for you to do a conversion.
2. What will it cost? When you convert, you pay the tax on the assets converted as if you took a taxable withdrawal of those assets. You add the amount converted to your other taxable income and pay tax on the combined income at your tax rate. For example, you are single, have taxable income of $75,000 in 2010, and are deciding whether to convert your $100,000 Traditional IRA to a Roth IRA. Without the conversion, your tax bill is $14,900. With the conversion, it is $42,900. You should determine in advance where you would get the extra $28,000 to pay the tax. For conversions done in 2010, there is a special rule that lets you divide the conversion amount in two and add each half to your taxable income in 2011 and 2012. That special rule will not be available in other years.
3. Should I do it this year? The only thing special about this year is that it is the first year that singles or couples with income over $100,000 are allowed to do a conversion. Taxpayers with income under $100,000 have always been allowed to do a conversion. You should consider if your income will be lower in some future year than it is this year when you think about the timing of a Roth conversion. Converting when you have less taxable income means you will probably pay tax at a lower tax rate.
4. Why do it? For many people, the motivation is to pay taxes now, and let the Roth IRA grow tax-free in the future. These people think income tax rates will be higher in the future. Currently, tax law says that any money withdrawn from a Roth IRA after it has been in the account for five years, and the account owner is over age 59 1/2 is tax-free. Others expect their taxable income to be higher in the future, which will bump them into a higher tax bracket. Some want to lower the amount of their taxable Required Minimum Distributions that they need to take from retirement accounts starting at age 70 1/2. Some plan to leave the Roth IRA for their children to withdraw from tax-free, so consider the taxes paid on the conversion as a gift to their children.
5. What not do it? It is possible income tax rates will not be higher in the future. We may switch to a sales tax, flat tax, value added tax, or consumption tax that will make the income tax you pay on the conversion worth less. Or it’s possible that your income tax rate won’t be any higher since your taxable retirement income will be lower than your current income. If the investments in the Roth IRA go down, you may end up paying tax based on the value at the date of conversion, not the value at the time you pay the tax. You may not pay enough income tax in advance, triggering a penalty from the IRS for underpayment of estimated taxes. Your future income (in the year of conversion or farther out) may be quite different than you expect it to be, causing you to regret making the conversion. The higher income from the conversion may trigger changes to things you never considered, such as college financial aid, Medicare premiums, or alternative minimum tax. Also, if you have both deductible and non-deductible Traditional IRAs, you can’t just convert all of the non-deductible IRAs and say the tax has already been paid on them. There is a more complicated formula you must use if you have both deductible and non-deductible IRA accounts.
6. Change your mind? There is the possibility of undoing the conversion if things don’t work out as planned. For a conversion done in 2010, you can undo or "recharacterize" it up to the date of filing your 2010 federal income tax return. If you ask for a 6-month extension of time to file, that filing date would be October 17, 2011. So if the assets fall in value, you can’t scrape up the money to pay the tax, tax laws change, or your personal situation changes, you can undo the 2010 conversion. You can convert your Traditional IRA again, but only in a calendar year after the original conversion, and at least 30 days after any recharacterization.
7. Still confused? If it seems like there is a lot to think about, then you are beginning to understand why experts caution this is not a simple decision. If you are considering a Roth conversion, you may want to discuss it with your tax preparer, your estate-planning attorney, and a fee-only financial advisor. Your tax preparer can keep you from having any surprises crop up when you prepare your taxes in the year of a conversion. Your estate-planning attorney can help you be sure your beneficiary designations are correct; that your durable power of attorney form allows a recharacterization; that any estate tax consequences are considered; and that you are not losing any asset protection. A fee-only financial advisor can help you see if a conversion will cost more than the expected benefits, help you structure the future investments to ease any recharacterization, keep your assets properly allocated, and help you decide where the money will come from to pay the tax.
Prepared by Faye Kathryn Doria, EA, CFP® of Financial Guidance Associates, Inc.