These days there is a lot of talk about Roth Conversion. Roth conversion involves conversion of a traditional IRA account to Roth IRA. In the year of conversion the entire conversion amount is taxed as ordinary income if the original contributions to traditional IRA were from pre-tax dollars. Until the end of 2009 IRS allowed this conversion only to those with adjusted gross income of up to $100,000. However, starting 2010 this conversion is available to all. So why would someone convert his/her traditional IRA account to Roth? The advantage of Roth IRA is that any gains in this account are not taxable for the purpose of Federal taxes. However, that advantage only holds true if income tax rates in future go up or your retirement income in future puts you in a higher tax bracket. Roth IRA also does not mandate you to take required minimum distributions (RMD) when you are age 70 ½. Although that may hardly be an advantage to those with limited retirement assets. Roth conversion allows IRS to collect the taxes sooner on pre tax savings in regular IRA accounts. For most people Roth Conversion may not give any tangible benefits. However, here are some of the things you may want to consider to evaluate the benefits of Roth Conversion. There are several calculators available online to let you decide whether to convert or not but all would require you to make some assumptions based on these considerations.
1. Income Taxes:
Income tax is by far the most important consideration for Roth Conversion and that is based on our individual views. No one knows what future holds for income taxes. If you think that future income tax rates during your retirement will be higher than now and you will have substantial retirement income to put you in a higher tax bracket then it makes sense to convert now. But if you think your effective tax rate would be same or lower during retirement (reduced income) then it does not make sense to do a Roth Conversion on the basis of income taxes. Mathematically, there is no difference between tax deferred growth in a traditional IRA account versus tax free growth in a Roth IRA account if your tax rate is going to be same.
If your IRA account has both pre tax and after tax contribution and you are converting only a portion of your IRA account then you will have prorated amount taxed. Other than state tax rates, a significant consideration needs to be given to different sources amount of income during retirement. They include RMDs from pre tax accounts, any pension income, social security benefit, Taxable portfolio. Note that long term capital gains taxes and dividend income taxes in a non taxable account are applied at a lower rate than ordinary income. So, just because you have $2 million in a non taxable account and it produces a decent amount of income via long term capital gain and dividend, it doesn't automatically put you in a higher tax bracket.
2. Income Tax Payment:
Payment of income tax could be from the account itself or you can write IRS a check from your savings. Be careful if you take the money out of your IRA balance to pay for taxes as that amount may be subject to additional 10% early withdrawal penalty if you are not already 59 ½. So, you need to have enough cash available to pay for taxes. To make the tax payment easier, IRS is allowing to splitting the tax bill over 2 years, half in 2011 and half in 2012. It can go into 2011 and 2012 because the tax filing deadline for the previous year's taxable income is April 15 th of the following year. Here the opportunity is really to look at the amount of tax bill and if it is a lot of money for you and you are paying it from your savings then what is its opportunity cost. If due to market downturn your IRA account has taken a hit then Roth conversion now (if you are eligible) or early in 2010 would reduce your tax bill. Again, it doesn't offer any tax advantages as such.
3. Wealth Transfer:
If you are generally well off and are likely to pass on your retirement savings in a traditional IRA (or Rollover IRA) account to your children then converting this to IRA makes sense. This is based on the notion that gift and estate taxes are likely to stay for foreseeable future. The conversion in this case will increase (step up) the cost basis for heirs reducing their tax liability. Note that if estate taxes are rolled back to pre 2001 level, they are much higher than ordinary income tax rates. However, not that IRD (Income in respect of decedent) deduction for the beneficiary makes the Roth conversion less attractive.
4. Additional Contribution Opportunity:
Once you have a Roth IRA account, one could argue that on a go forward basis you can contribute more because the contributions are with after tax dollars. This is simply because the contribution limit for both traditional IRA and Roth IRA is same, $19,000. But unlike traditional IRA, Roth IRA has income phaseout may limit the contribution amount. Perhaps a more important consideration in this regard is having money to be able to contribute.
5. Early: Withdrawal Consideration:
Early withdrawal (principal first) from a Roth IRA account after Roth conversion is not applied if there are no subsequent withdrawals for next 5 years. Of course, there is no early withdrawal penalty from this account if you are already 59 ½.
If you lost your job and if your income level was low, converting a traditional or Rollover IRA to Roth may be a good strategy. It is particularly useful to perform this conversion during a significant market downturn. The idea is, during a down market since your account balance is expected to be low, your tax liability will also be less. After conversion, when the market picks up your earnings will grow Federal tax free.
Roth Conversion is not just limited to regular IRA accounts, it is available for converting a Roth 401(k) account as well. But this is called a rollover as opposed to conversion since there is no tax implication. Unlike the traditional IRA and pre-tax 401(k) savings, the Roth 401(k) account allows you to contribute after-tax dollars. The earnings on the contribution grow tax free. Withdrawals from Roth 401(k) accounts during retirement period are tax free from Federal tax perspective. However, Roth 401(k) carries the required minimum distribution (RMD) requirements similar to a regular 401(k) account. The benefit of converting to Roth IRA in this case is limited to not having to take RMD at age 70 ½.
