To Roth or Not To Roth

Congress lifted the income ceiling in 2010 for conversion of a traditional IRA to a Roth IRA. So lots of people are wondering if a conversion is a good idea.  The answer is – as it so often the case – that it depends. 

What’s the difference between the two types of IRAs?  Contributions to a traditional IRA might be partially or fully tax deductable, so this type of retirement account has some or all of the balance subject to tax when the money is withdrawn.  Also, with a traditional IRA, you are required to withdraw a portion of the account every year beginning when you turn 70½ and those withdrawals are taxable.  Contributions to a Roth IRA are never tax deductible, but withdrawals aren’t subject to tax.  Also, you are never required to withdraw the money from a Roth.  Both types of IRAs have a 10% penalty if you take money out prior to your age 59½, with a few exceptions. 

Converting from traditional IRA to Roth means that the taxes need to be paid on the taxable portion of the traditional IRA, which sometimes means the entire amount.  During 2010, that converted amount can be taxed partially in 2010 and partially in 2011.  But unless you know you’re going to drop into a lower bracket in 2011 due to a life event – retirement, quitting a job to go to school full time, taking a big pay cut – spreading the tax over two years probably doesn’t make sense.  We know the tax brackets in effect for 2010 and it’s likely that they’ll be higher in 2011.

It’s important to remember that you don’t have to convert your entire IRA.  You could decide to convert just part of it.  So if the top IRS tax bracket you are subject to is 28%, you could convert enough of your IRA to a Roth that you wouldn’t have income pushed into the next tax bracket and leave the rest in your traditional IRA in place.  That Roth balance will now be available in your retirement years to be withdrawn only if you want to withdraw it and will be tax free if you do use it. 

So who is a Roth conversion most appealing to?  If you are in a lower tax bracket this year than normal, you might want to consider it.  Maybe you just retired or you’ve been laid off or had a pay cut in your household.  If you are ten or more years away from retirement and don’t expect your tax bracket to go down much when you leave the workforce, that’s another favorable thing.  So if you’ll have a pension that will pay you when you stop working or your IRA is really large, you might want to look at a conversion.  Ironically, the people who haven’t been eligible this year – high income earners – often have the hardest time justifying a conversion.  I recommend doing a Roth conversion prior to age 59½ only if you have enough cash outside the IRA to pay the tax.  So paying between 28% to 35% to the IRS (on top of any state income tax) to move into a tax free instrument is a difficult pill to swallow at just about any time.  But to do it during a recession when it’s especially important to keep lots of funds liquid in case of a loss of income or another financial emergency is too aggressive for some of these folks.  For people already in retirement, a low stock market can be a good time to do the conversion.  If you account values are down, moving some money to the Roth will allow that money to grow tax free.  Assuming growth on the account of 8%, it takes about three to five years to get back what was paid in taxes.  From then on, all the growth I  the Roth puts you ahead in the tax game on your retirement funds. 

Still undecided?  Make an appointment with a financial planner to see if your particular situation could make sense for a conversion.  Your situation is unique and one of the factors that can’t be quantified is whether or not you’re comfortable with the transaction.