The “Roth Conversion” opportunity has received lots of media coverage and advertising dollars from financial institutions. You might be afraid you’ll be left out of this once in a lifetime opportunity. But the decision to convert is far from a “no-brainer”. This is because the amount that you convert will be subject to income taxes. Though the taxes can be spread over two years, and there is no early withdrawal penalty, this cost must be weighed against the potential benefits.
A “Roth conversion” is simply transferring money from a tax-deferred account, such as an IRA, to a Roth IRA account. The amount converted is treated as a withdrawal and is taxed as income in the current year. Before 2010, only investors with adjusted gross incomes below $100,000 were eligible for Roth conversion. This year, the income limit is suspended, and any investor with tax-deferred retirement accounts such as traditional IRAs, 401(k)s, 403(b)s, SEP-IRAs, and SIMPLE-IRAs can convert some or all of the balances to a Roth IRA.
Most traditional retirement accounts allow investors to make tax-deductible contributions that may grow tax-free, but future withdrawals are taxed at ordinary income tax rates. Roth IRAs are unique because they are funded with after-tax dollars, and the growth and future withdrawals are not subject to income taxes.
The Roth conversion might especially appeal to investors who don’t expect to need all of their retirement account assets and intend to leave some portion to their heirs. Beneficiaries of Roth IRAs will likely benefit from the continued tax-free compounding and tax-free withdrawals over their lifetimes so paying the taxes to convert some portion of a regular IRA may help to maximize the total future benefit to them.
If your estate plan includes the likelihood that your retirement account will be left to charitable causes then it would not make sense to convert these balances. Since these organizations aren’t subject to income taxes, paying taxes on the conversion today wouldn’t save any taxes in the future.
If you do expect to need most or all of your retirement account balances to fund your own retirement, then the question comes down to whether shifting the tax liability forward at today’s rates is favorable to continuing to defer taxes until withdrawals are made and paying taxes as you go, at future rates.
There are many variables, including the timing of withdrawals, future tax rates, projected income, expected returns, etc. that don’t allow a one-size-fits-all decision. For example, if you expect to have significantly below-normal taxable income in 2010, or you expect that your income tax rate will be significantly higher in retirement than they are today, it might make sense to do a full or partial conversion. For many investors, the potential benefit is too small and too uncertain to offset the certain pain of voluntarily paying additional income taxes!
We’d be happy to perform an analysis based on your specific circumstances and goals.
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