Weigh the good and bad before converting Roth IRA
TERRY SAVAGE email@example.com Aug 19, 2010
Updated: May 3, 2013 12:14PM
I've been going back and forth about converting an IRA to a Roth this year. What do you think?
A. I've written about this special opportunity to convert a traditional IRA to an after-tax Roth IRA this year, regardless of your income level. (Until this year, conversions could only be done if your modified adjusted income was under $100,000.) But if you do a conversion in 2010, there is no income limit.
That's the good news: You can roll your traditional, pre-tax IRA into a Roth IRA that will grow completely tax free when you withdraw it in the future. And with a Roth IRA, you will never be forced to take minimum required annual distributions if you do not need the cash.
Before making a conversion decision, you have to sort out all the good news from the bad.
Bad news: You must pay income taxes on all that money you are converting into the Roth IRA. Remember, your original traditional IRA contributions were made on a pre-tax basis, and the growth in your account was also never taxed. Similarly, if you converted an old 401(k) account into a traditional IRA, this is all pre-tax money. So you must pay ordinary income taxes at your current marginal tax bracket on the money you convert.
Good news: For conversions done in 2010, you can defer the taxes for the next two years -- paying half in 2011 and the other half in 2012.
More bad news: You should pay the taxes due on the conversion with money you already have outside your IRA. If you withdraw money to pay taxes, you defeat the purpose of the conversion because you have less left inside the new Roth to grow tax-free. Even worse, if you're under age 59Â½, you'll pay a 10 percent early withdrawal penalty on the money you take out to pay the taxes!
Good news: This might be a good year to convert your old IRA. If you've lost money in the stock market, the value of your account will be lower, so there will be less tax to pay.
And if you believe tax rates are going to rise -- even during your retirement years -- it might be a good time to pay that tax bill.
Bad news: If you do a huge rollover this year, it could move you into a higher income tax bracket. And that could, in turn, impact the amount you pay for Medicare premiums, or result in some of your Social Security benefits being taxable. The cost for higher Medicare premiums could be as much as $3,000 per year for a single person.
And the impact isn't only on seniors. If you're a younger worker, it could impact your financial aid situation or a deferral of student loan repayments. So be sure to check with your accountant to understand the full impact of this conversion decision.
"Iffy" news: Here's something you should consider, although no one can give you a firm answer. It's understandable that Congress passed this provision because it will bring in more taxes sooner. But what happens down the road? It's highly likely that you'll be in a higher tax bracket, even if you're retired, so tax-free withdrawals will look like a good deal.
With looming deficits, will Congress keep its promise of future tax-free withdrawals from a Roth? Or will it institute some kind of income-based surtax down the road on Roth withdrawals made by people in higher tax brackets?
This is the question without an answer. Or as "Dirty Harry" asked: "Do you feel lucky?"
If you're even thinking about doing a conversion, now would be the time to discuss these issues with your tax adviser, so you are not surprised by the bill and the consequences. And now is the time you'll be able to deal with your mutual fund or brokerage custodian more easily, avoiding the last-minute rush that will certainly be a headline story at year end.
One final thought: Conversion is not an all-or-none decision. You might decide to convert only one IRA, or to split your IRA and convert a portion. Just be sure to name a beneficiary for your new Roth IRA -- an individual who will be able to inherit any balances when you die and keep the account growing tax-free.
Terry Savage is a registered investment adviser. Post questions on Terry's blog, terry savage.com, and at suntimes.com/savage.
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