The following post has been completely updated from the original version that appeared on January 25, 2010.
Tax-free income at retirement – who wouldn’t want that if they could get it? And you can if your money is invested in a Roth IRA. That’s why Roth IRA conversions are a hot topic. With the Roth, any withdrawals after age 59 1/2 can be taken tax-free (as long as the account is open for a minimum of five years). That’s the principal and the income earned and accumulated on it!
Not only does that make a compelling case for having a Roth IRA, but perhaps even more so for converting existing traditional IRAs to a Roth as well. And converting a traditional IRA to a Roth IRA is actually quite easy. You just have to notify your retirement account custodian (bank, brokerage company, mutual funds, etc.) that you want to convert your traditional IRA—or just a portion of it—to a Roth IRA and they’ll take it from there. You can even keep the same investments you had in the traditional account.
The more you have in your Roth account, the more you’ll have available for tax-free withdrawals at retirement. Good deal?
Sometimes…and sometimes not.
How do you know the difference?
When Roth conversion makes sense
When most or all of your IRA contributions weren’t tax deductible. Since you received no tax benefit on the original IRA contribution, the conversion won’t be considered taxable income and no tax liability will be created by the conversion of your contributions. You will have to pay tax on the accumulated earnings on your IRA, but you’ll be converting your IRA savings from tax-deferred (the traditional IRA) to tax-free (the Roth IRA). It doesn’t get any better than that!
When you have a year in which your income will be lower than usual, dropping you into a lower tax bracket. A job loss or a large business loss could lower not only your taxable income but also the tax bracket you’re in. This will also lower the tax consequences of a Roth conversion.
When it looks certain that your income in retirement will be higher than it is now. Traditional IRAs are tax-deferred; Roth IRAs are tax-free on eligible withdrawals. If you believe your income will be higher in retirement than it is now, you may want to trade the deferral that a traditional IRA offers now for the tax-free income that a Roth provides in retirement. For high income retirees, tax diversification is a critical factor in retirement planning.
When retirement is a long time off. If a Roth conversion creates a tax liability, you’ll need time to recover that cost through future earnings. Because of that, a conversion will make more sense the farther you are from retirement.
When you have the cash available to pay the increased tax liability. The emphasis here needs to be on the word cash. This is actually more complex than it sounds at first. You don’t want to be in situation where you will be forced to liquidate investment assets in order to pay your tax bill, when the liquidation could itself cause a change in your tax liability. The sale of appreciated stock is just such an example. If the gain is substantial, you could be looking at an even higher tax liability on top of the Roth conversion.
Neal’s note – If you don’t think you will need this money and mainly want to benefit your Roth IRA beneficiary, the conversion is super attractive.
And when it doesn’t…
When the conversion will push you into a higher tax bracket or phase out generous deductions and/or credits. The best word I’ve ever heard to describe the tax code is “Byzantine,” and if you don’t know what that word means, that’s exactly how most people feel about the tax code. Not only are there various income tax brackets, but there is also a cornucopia of deductions and credits that kick in, phase out or completely disappear at various income levels. You need to be aware of the impact this will have on the final cost of a Roth conversion. If you convert your IRA into a Roth and later regret it, you can do a Roth recharacterization, but why not get it right the first time? Get help with this – see the last section of this post…
When you’re in a higher tax bracket than you were in when you took the original IRA deductions. Let’s say that you were in the 10% tax bracket when you took your IRA deductions, but you’re now in the 28% bracket before adding a Roth conversion to the mix. You’ll be swapping a 10% benefit for a 28% cost and locking in an 18% loss.
When a conversion will trigger the Alternative Minimum Tax (AMT). While we normally think of the AMT as applying to “the rich,” it’s increasingly falling on the middle class. A Roth conversion can trigger such an event. The AMT may not be a deal breaker, but you certainly want any conversion to minimize the effect.
You don’t have the money to pay the increased tax that the conversion will generate. If a Roth conversion generates a tax liability you can’t afford to pay, then you can’t afford to do it. Borrowing to pay the tax bill only adds a fresh liability to an already complicated mix, and you don’t need that.
When it’s pretty certain that you’ll be in a much lower tax bracket in retirement than you’re in now. If you have strong reason to believe that your tax bracket in retirement will be somewhere between minimal and non-existent, you may not want to convert. In that case, tax-free income won’t be as attractive. More important, you don’t want to give up a 28% tax deferral during your working years to avoid a zero to 10% bracket in retirement.
Before you set out to convert
While the actual conversion of a traditional IRA to a Roth IRA is a simple process, the tax implications of doing so are not. The tax consequences for making a mistake on conversion can be disastrous. If you’ve crunched the numbers and feel certain that a conversion is the right course for you, you still have one more incredibly important step to take.
A Roth conversion is akin to a matrix – a very complex matrix – and you should never venture into it alone. Before taking the plunge, be sure to seek the advice of an attorney, a CPA or a financial planner who specifically has Roth conversion experience. The fee that you pay to a trained professional to help with the conversion will be some of the best money you’ve ever spent.