Roth IRAs: To Convert or Not To Converts
To convert or not to convert? That is the question that many taxpayers are currently asking with respect to converting their traditional IRAs into a Roth IRA. Unfortunately, there is not a clear yes or no answer.
Why all the fuss all of a sudden?
Until recently, the Roth IRA eligibility requirements limited the number of taxpayers who could have a Roth IRA. Taxpayers with income over a specified amount could not have a Roth IRA account. Beginning in 2010, the income limitations for Roth IRA rollovers has been lifted, although the income limitations for Roth IRA contributions remain. Thus, many taxpayers who previously could not have a Roth IRA are now trying to determine whether or not it makes sense for them to rollover amounts from their traditional IRAs to a Roth IRA.
What are the distinctions between a Roth IRA and a traditional IRA?
A Roth IRA, like a traditional IRA, is a retirement fund that grows in an account sheltered from current income taxes. The key distinction is that a Roth IRA, unlike a traditional IRA, is not subject to income taxes upon withdrawal. This is because a Roth IRA is funded with after-tax dollars. Furthermore, required minimum distributions, starting at age 70 1/2, are not required from Roth IRAs.
What are the tax consequences of converting to a Roth IRA?
Since an account funded with before-tax dollars is being rolled over into an account designed to hold after-tax dollars, there will be income taxes due on the amounts rolled into a Roth IRA (other an amounts attributable to after-tax dollars such as previously non-deductible contributions). These amounts will be taxed at ordinary income tax rates. A unique opportunity exists with respect to rollovers completed in 2010. A taxpayer can elect to include the income in 2010 and pay the taxes due by April 15, 2011 or the taxpayer can elect to include 1/2 of the income in 2011 (paying taxes due by April 15, 2012) and 1/2 of the income in 2012 (paying taxes dues by April 15, 2013). This would ordinarily be considered a "no brainer," but in today's political environment, it is quite possible that deferring and spreading the tax over 2 years could result in a higher total tax bill if, as expected, income tax rates are raised.
Who should consider converting to a Roth IRA?
The "ideal" taxpayer that should consider a Roth IRA conversion in one that has several of the following characteristics:
- Can pay the income taxes upon conversion with fund other than those being converted
- Does not need the funds that will be converted to meet cash flow needs
- Has a long time horizon until retirement (this applies to someone that may need the cash flow from the converted funds in retirement)
- Expects their income tax bracket, or that of their heirs, to be lower in retirement than it is currently
- Has the ability to offset the income tax on conversion with deductions or credits (such as charitable contribution or net operating loss carryforwards)
- Value of funds being considered for conversion are depressed, but expected to increase substantially in the future
If several of the items listed above are "in play", a Roth IRA conversion should be considered and an analysis of the costs and benefits should be performed based upon the taxpayer's particular facts and circumstances. The answer will not be the same for everyone and certain assumptions will have to be made that could end up differing with the passage of time. Also, please keep in mind this does not have to be an "all of nothing" decision. The law does not prohibit a partial conversion...so a taxpayer can hedge their bets by leaving some funds in a traditional IRA.
Heads you win, tails you win.
If a taxpayer converts a traditional IRA to a Roth IRA and later, for whatever reason, decides it was not the best decision, the law allows the taxpayer to undo the conversion. To undo a conversion, the taxpayer needs to have the funds transferred from the Roth IRA back to a traditional IRA no later than the due date, including extensions, of the tax return for the year of conversion. If the conversion occurred anytime in 2010, even as early as January 1, the taxpayer can undo the conversion as late as October 17, 2011 (October 15th falls on a Sunday). The "extended due date" for the conversion is applicable even if the particular taxpayer did not extend their return. If the taxpayer then wishes to re-convert back into a Roth IRA, the taxpayer must wait until the later of the beginning of the year following the year of the original Roth IRA conversion or 30 days after the original conversion was undone. Thus, if a taxpayer converted a traditional IRA to a Roth IRA on March 1, 2009 and, due to the fact that the Roth IRA decreased in value as of October 1, 2011, the taxpayer undid the Roth IRA conversion as of October 1, 2011, the taxpayer could then re-convert back into a Roth IRA no earlier than November 1, 2011.
As you can see, there are many factors to consider before converting a traditional IRA to a Roth IRA. The best advice is to discuss this with your advisors, make some assumptions, have them provide you with the appropriate analysis and then relax . . . there is no right or wrong answer and you can change your mind up until October 15th of the year following conversion.
Roth IRA Conversion Analysis Questionnaire Worksheet
Answer the following questions, then contact Lauren Carnes at (617) 471-1120.
Name(s):
- What is the current value of your traditional IRA (if multiple IRAs, please list each separately)?
- How much of your traditional IRA consists of non-deductible contributions (if multiple IRAs, please list separately)?
- What is your date of birth?
- At what age do you plan to retire?
- What is your annual rate of return on your IRA?
- What is your anticipated adjusted gross income, prior to any IRA conversion, for the year of
conversion (we will use this to determine your tax rate, including amounts converted)? - What is your anticipated adjusted gross income during retirement (we will use this to determine your tax rate in retirement)?
- Do you have "outside" funds to pay any taxes as a result of an IRA conversion?