Should You Convert to a Roth IRA?

Beginning January1, 2010 anyone can convert their Traditional IRA or in many cases their balance in an employer plan, such as a 401 (k), 403 (b) and 457 plan to a Roth IRA. Previously, only those with income less than $100,000 could do so. Is this a good idea? While conversion can be an important part of one’s financial and estate planning, it is a complex decision based upon many factors and assumptions. Only certain taxpayers will benefit from such a conversion. Furthermore, the decision to convert goes against the tried and true strategy of deferring income taxes as long as possible.

A Traditional IRA and employer plan usually consist of untaxed contributions and earnings thereon although after-tax contributions can also be made. The earnings always grow tax deferred. Distributions generally must begin when the owner attains age 701/2 (the required minimum distribution). Distributions of pre tax contributions and of earnings are taxed at ordinary income tax rates.

A Roth IRA consists of contributions that have already been taxed. Distributions of contributions and income are tax free provided they are made after the fifth anniversary of opening the account. There is no required minimum distribution from the Roth IRA prior to the death of the owner.

Conversion to a Roth IRA requires the owner to pay tax currently (not when distributed) at ordinary income tax rates on the untaxed portion of their Traditional IRA or employer plan. A 10% penalty would also be due on the taxable amount if the owner was less than 59 1/2 years old and had established the Roth IRA within the past 5 years. Why would one in essence prepay this tax? They would do so in order to have future earnings distributed tax free and perhaps to avoid required minimum distributions. They could also be counting on the income tax rates being higher in the future. This may not be a bad assumption due to the growing federal deficit. In fact if Congress does nothing, the top federal rate will rise automatically from 36% to 39.6% in 2011 and thereafter.

The ideal candidate for conversion is a wealthy individual who will not need and does not plan to use the IRA or employer plan funds during his or her lifetime. They would like to leave as much of these funds as possible to their descendents. Because there is no required minimum distribution for the owner, over time the tax free buildup of Roth earnings should more than offset the current tax on conversion. The ideal candidate would also be concerned about the federal estate tax. The ultimate beneficiary pays no income taxes because this ideal candidate has paid it for them when converting to the Roth IRA. The tax payable at conversion reduces one’s taxable estate with no estate or gift tax consideration.

Individuals not planning to use these funds for ten years or more also are a good candidate for conversion. The benefit of ten years of income compounding tax free would probably offset the detrimental present value of the income tax due on conversion. Conversely, an individual planning on using the funds in their near future would not have enough years of tax free compounding necessary to overcome the detriment of paying taxes on the conversion before the funds were distributed.

It is somewhat ironic that high income individuals (unmarried taxpayers with income greater than $120,000 and joint filers with income greater than $177,000) and married filing separate filers with income greater than $10,000 cannot contribute to but can now convert to a Roth IRA. These individuals by making annual non deductible contributions to a Traditional IRA (such contributions are not limited by income) and subsequently converting these contributions to a Roth would in essence be funding a Roth regardless of their income.

Taxes on the conversion are normally due for the year in which the conversion is made. For example, if you convert in 2011, your 2011 income will include the untaxed portion of your Traditional IRA and employer plan and the taxes due to the conversion will be due on April 15th, 2012. Taxpayers converting to a Roth IRA in the year 2010 though will have the option of including one-half of the conversion in their 2011 taxable income and one-half in their 2012 taxable income in addition to the option of including all of the conversion in their 2010 income.

Another favorable aspect of the conversion option is the ability to change one’s mind. This may happen if the market values of the assets drop significantly after conversion. In such a case, the owner can “re-characterize” the converted Roth assets as Traditional IRA assets. Re-characterization can occur as late as the extended due date of the tax return (October 15th of the year following the year of conversion). For this reason, one may want to convert a Traditional IRA or balance in an employer plan into multiple Roth accounts in order to be able to re-characterize only those investments that have depreciated in value. Finally one can elect to “reconvert” the “re-characterized” Traditional IRA back to the Roth IRA after 30 days.

Conversion to a Roth IRA may very well be an important part of your financial strategy. You should consult your financial advisor as soon as possible, because if it is the right strategy for you, the sooner in 2010 you convert, the less tax you will have to pay upon converting.