Roth IRA Conversion Q & A - "To Do or Not To Do, That is the Question"
Since 2010, everyone has the opportunity to convert a Traditional IRA into a Roth IRA. In prior years, only those who had an adjusted gross income of less than $100,000 were able to convert to a Roth IRA. Because of the popularity of Roth IRAs and since now anyone is able to convert to one, this subject has become a hot topic in financial circles.
How does it work?
If you decide to convert, you will owe federal income tax on amounts converted that have not been already taxed (i.e. – the taxable amount will be added to your gross income for the year converted). Hence, if you have after-tax (non-deductible) amounts in a Traditional IRA, you would not have to pay taxes on this amount since it has already been taxed.
What are the benefits of a Roth IRA?
Future withdrawals from a Roth IRA are free from any federal income taxes as long as you are over age 59 ½ and have had the account for at least five years. You are also not required to take yearly required minimum distributions (RMDs) at age 70 ½ as other retirement accounts entail. If you do not need the distributions for yourself, this could leave more money for your beneficiaries, especially since it would be free from federal income tax. This component alone makes a Roth IRA a very attractive vehicle to maximize the transfer of wealth to your heirs. It is important to note that while the account holder is not required to take distributions during their life, beneficiaries must take RMDs upon inheritance.
Roth IRAs also provide a form of tax diversification. For many people, most of their retirement savings are in tax-deferred accounts (such as a 401(k) or Traditional IRA), which when distributed will be subject to income taxes. If you have a combination of tax-free accounts (like a Roth IRA) and tax-deferred accounts, there will be greater flexibility from a tax perspective for your income needs during retirement.
What are the implications of converting with the uncertainty of future tax rates?
An important factor to consider when making the decision to convert lies with the uncertainty of future tax rates. Many people believe tax rates will go up in the future. By converting to a Roth IRA, you will be paying taxes now and future withdrawals would be exempt from any income taxes, so it does not matter if income tax rates do rise in the future. For the vast majority of people, by converting, it will put you in a higher tax bracket during the conversion year and depending on the amount converted, may put you in the highest tax bracket. Due to being in a higher tax bracket, certain tax deductions or credits generally available to you may disappear in the conversion year.
Should I pay the taxes incurred from the IRA or from other sources if available?
It is definitely advantageous to pay the taxes incurred using other sources. If you use assets from the IRA, you not only lose the advantage of tax-free growth on the assets used to pay taxes but if under age 59 ½, you will also incur an early withdrawal penalty of 10%. It is also important to remember any tax consequences (capital gains) generated by selling non-retirement assets to cover the conversion tax liability.
What is the "pro-rata rule"?
If you have both tax-deductible (pre-tax money) and nondeductible (after-tax money) money in your IRA, you cannot convert only the nondeductible assets. The conversion is taxed based on the proportion of tax-deductible (taxes still owed) and nondeductible (taxes already paid) assets in all of your IRAs.
Is it all or nothing? Do I have to convert my entire Traditional IRA?
No, you are able to convert as much or as little as you wish of your account value to a Roth IRA. When you are not converting the entire Traditional IRA, keep in mind that the pro-rata rule applies if a portion of your IRA consists of nondeductible contributions.
Can I convert to a Roth IRA from my employer-sponsored retirement plan?
Yes, a rollover from an employer-sponsored retirement plan can also be converted directly to a Roth IRA. If there is a Roth 401(k) portion to your account, those amounts would be rolled over tax-free while any pre-tax portion would be subject to income taxes.
Were the Roth IRA contribution income limits removed?
While the income limits on conversions to Roth IRAs were removed, the income limits on contributions to Roth IRAs are still in place. For 2010, individual filers who have income of $120,000 or above (joint filers of $177,000 or above) are not able to make contributions directly to a Roth IRA. It is important to note that there are no income restrictions on contributions to Roth accounts in an employer-sponsored retirement plan.
A possible workaround for higher income earners could be to make the allowable contribution into a non-deductible Traditional IRA, which has no income limits, and then convert the account into a Roth IRA. In this instance, the pro-rata rule would apply and depending on any other Traditional IRA assets you may have, this could somewhat negate this workaround. If the pro-rata rule applies due to existing Traditional IRA assets, using this workaround with a non-working spousal IRA could be most effective.
What if after the fact I feel as though I made a mistake and should not have converted?
You are able to do a re-characterization, which would allow you to "un-do" a Roth conversion. A re-characterization allows you to revert back to a Traditional IRA (it does not allow you to return to an employer-sponsored plan) and reverses the tax implications. There are rules and time-limits to be aware of when re-characterizing.
Can I convert an IRA that I inherit?
An existing Inherited IRA cannot be converted into an Inherited Roth IRA. However, a non-spousal beneficiary of an employer-sponsored retirement account is able to convert the inherited assets directly to an inherited Roth IRA. In this case, it is important to convert directly from the inherited employer-sponsored account since if these assets are rolled over into an inherited traditional IRA first, the ability to then convert to the Roth will be lost. Spousal beneficiaries can always convert directly to a Roth IRA.
Bottom line, should I convert or not?
If you answer yes to one or more of the following questions, a Roth IRA conversion may make sense for you:
1) Do you have enough money outside of your retirement account to pay the taxes due?
2) Do you have other, non-IRA assets to use for income during retirement and want to pass on your IRA assets to your heirs?
3) Can you wait to access these funds after 5 or more years and after age 591/2?
4) Do you think you will be in the same or higher tax bracket when you need the money?
Ultimately, it seems to make sense to not pay additional taxes now if it can be avoided unless there is a clearly compelling advantage to doing so.
A Roth conversion has a hefty price tag for most people. For many people, the idea of writing a large check for taxes to the Internal Revenue Service makes them queasy.
Since each individual situation is unique, it is important to thoroughly analyze each situation before making any decisions. The tax implications and conversion rules can be complicated and it is important to discuss your situation with a financial professional and/or tax advisor. State taxes vary and are not included in this guide.
Tracy Burke, CFP, ChFC
Conrad Siegel Investment Advisors, Inc. Harrisburg PA