Download Should You Convert Your IRA?

Should You Convert Your IRA?
A tax law passed in 2006 included a nifty gift for those who save in an IRA. Since 2010, investors
of all income levels have been able to convert their traditional IRA assets to Roth assets, though
in doing so, they must pay ordinary income taxes on any deductible contributions and
investment earnings. (Prior to 2010, your adjusted gross income had to be $100,000 or less for
you to be able to convert, whether you filed your tax return as a single or you were part of a
married couple filing jointly.)
Note, however, that simply having some Roth IRA assets due to a conversion won't necessarily
make you eligible to make future contributions to a Roth. As always, income limitations apply
for Roth contributions; in 2013, individual tax filers making more than $127,000 and joint filers
earning more than $188,000 cannot make Roth contributions. So making the conversion isn't,
unfortunately, an automatic gateway into future contributions.
Advantages to Conversion
It may be hard to get excited about paying taxes now--as you would if you made the
conversion--versus letting the assets sit in your traditional IRA and paying taxes later.
Traditionally, the calculus about whether to convert from a traditional IRA to a Roth required
you to project whether your income would be higher or lower in retirement than it is now, a
question that's very difficult to answer if you have more than a few years until retirement.
However, even though tax rates already went up for high-income earners in 2013, the odds are
good that taxes across the board will be higher in the future as Congress works to address the
country's fiscal issues--a process that will likely involve both spending cuts and tax hikes. If you
share that view, you'll want to seriously consider any option to pay taxes now rather than
waiting until later.
The Roth IRA also gives you more flexibility than you'll have with a traditional IRA. Notably, you
won't be required to take mandatory distributions from a Roth at age 70 1/2, as is the case with
traditional IRA assets. That's a huge boon if you don't expect to need your IRA assets during
retirement; you can allow those investments to grow and pass on a greater amount to your
heirs.
And while it's never ideal to tap your retirement savings prior to retiring, the Roth is a much
better option than a traditional IRA should you need to do so. If you convert to a Roth and five
years have elapsed since you made the conversion, you can withdraw the converted amount,
plus any additional contributions, prior to age 59 1/2 and you won't have to pay taxes or
penalties.
Possible Candidates for Conversion
In general, the younger you are, the more beneficial a conversion will be. That's because you'll
have more years to recoup the tax hit. That's not to say a conversion should automatically be
off the table if you're nearing or even in retirement, though. If it's fairly early in your
retirement, longevity runs in your family, and you won't need to put your hands on your IRA
assets for five years or even more, a conversion may well be worth it because you'll have a
good shot at recouping the tax hit. Moreover, if you're already retired and taking Social
Security, converting to a Roth could reduce the tax you pay on your Social Security income.
Although the conversion could bump up the amount of Social Security benefits that are taxable
in the year you do the conversion, the conversion could reduce your Social Security tax in
subsequent years. That's because Roth distributions don't factor into the calculation that the
IRS uses to determine which Social Security benefits are taxable.
You're also a good candidate for a Roth conversion if you've primarily made nondeductible
contributions in the past, because you won't owe taxes on those nondeductible contributions-only your investment earnings and deductible contributions will be taxed upon conversion.
You should also look at an IRA conversion if you have amassed a large estate. There are a few
reasons why. First, as noted earlier, the Roth doesn't require mandatory distributions, thereby
allowing your assets to compound and increasing the amount you can pass to your spouse or
heirs. The second key reason relates to estate tax. Because you've already paid tax on Roth
assets, the overall nest egg that you pass to your heirs will be smaller under the estate tax
system, and therefore could help to reduce your estate-tax liability. The traditional IRA assets,
by contrast, will be included in your estate-tax liability, even though your heirs will have to pay
taxes on those assets.
Finally, if you're unemployed or your income is currently appreciably lower than it normally is, it
can also be advantageous to convert. Provided you have the cash to pay the tax bill, your taxes
related to the conversion will be lower than they would be if your income were higher.
Who Should Think Twice
Clearly, an IRA conversion can make sense for individuals in many different situations. However,
there are other situations in which the conversion will be less beneficial. One of the key ones
will be if you don't have the money in other assets to pay the tax associated with the
conversion. If you're younger than 59 1/2 and your only option is to use part of the traditional
IRA assets to pay the tax, you'll pay a 10% early-distribution penalty on any assets you don't roll
directly into the Roth. Plus, you'll have less money at work for your retirement.
In addition, those who know they'll be in a significantly lower tax bracket in retirement should
think twice about converting. Also be careful if it looks like your conversion will push you into a
higher tax bracket in the year in which you convert. The risk is that you could disqualify yourself
for tax benefits, such as credits and deductions, that you would otherwise be eligible for.
In all of the above situations, though, you should be aware that you needn't convert all of your
IRA in one fell swoop. Partial conversions are also permissible. However, you can't pick and
choose which IRA assets to convert--for example, you can't convert all of your nondeductible
IRAs and leave your deductible IRAs intact, although that would be advantageous. Instead, each
dollar you convert will receive exactly the same tax treatment based on your aggregate IRA's
breakdown between deductible contributions/investment earnings and nondeductible
contributions.
For example, say you have $100,000 in an IRA that's composed of $30,000 in deductible
contributions, $10,000 in investment earnings, and $60,000 in nondeductible contributions. In
that case, 40% of every amount that you convert would be taxable upon conversion (that 40%
encompasses deductible contributions and investment earnings), whereas you wouldn't owe
taxes on 60% of your conversion (the percentage of your IRA portfolio represented by
nondeductible contributions). Each subsequent conversion that you do would receive the same
40% taxable/60% nontaxable treatment.
Logistics
If you determine you want to move forward with a conversion, it pays to double-check with a
financial advisor or tax specialist to make sure you're thinking through all of the variables. And
when you do convert, make sure you mind your P's and Q's. IRS Publication 590 (Individual
Retirement Arrangements) includes all of the nitty gritty details. Your investment provider
should be able to walk you through the forms you need to fill out for the conversion; some
investment providers now allow you to make the conversion using online tools.
Also know that if you convert your IRA from a traditional to a Roth, you needn't change your
investments--you're changing the tax treatment of those investments, not the investments
themselves. Finally, be mindful of the deadlines related to conversions. Whereas you have until
April 15 to make an IRA contribution, the conversion will need to be done by Dec. 31 to count
for that tax year.
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