A common question in retirement planning is, “What type of IRA is best: a Traditional IRA or Roth IRA?” The next logical question is, “Does it make sense to convert a Traditional IRA to a Roth?” The answers, of course, depend on your situation and goals.
The Roth conversion question is getting a lot of attention lately because the rules have changed for 2010 and beyond. There is no income restriction on converting a Traditional IRA to a Roth IRA. As a special rule for 2010 only, investors have the option to report the amount of income from the Roth conversion evenly in 2011 and 2012, or all in 2010.
As a reminder, here is a quick comparison of the Traditional and Roth IRA:
|Traditional IRA||Roth IRA|
|Funded with pre-tax dollars||Funded with after tax dollars|
|Grows tax deferred||Grows tax free|
|Withdrawals taxable||Withdrawals tax free*|
|Required Minimum Distributions by age 70 ½||No required minimum|
|Beneficiaries, other than spouse, are required to take distributions based on their life expectancy. Distributions are taxed.||Beneficiaries, other than spouse, are required to take distributions based on their life expectancy. Distributions are tax free.|
* There could be a penalty of 10% if the investor is not over 59 ½ years old, or if the account is not open for 5 years and earnings after conversion are withdrawn. Earnings do not come out until after all converted (taxed) funds are withdrawn.
You may want to consider converting to a Roth if:
- You expect the tax rate on your future withdrawals to be equal to or greater than the tax rate you pay on conversion.
- You have cash outside the IRA to pay the tax on conversion. If you have to withdraw money from your IRA to pay taxes, you probably won’t come out ahead by converting.
- You do not need some or any of your Required Minimum Distributions to live on.
- You have a long time frame for the money to sit undisturbed in the Roth. This allows tax-free compounding to make up for the lost taxable return on funds used to pay the tax.
- You wish to pass a valuable legacy to your heirs. Beneficiaries take required withdrawals based on their life expectancy, and the money comes out tax free. This allows for potentially many more years of tax-free compounding.
Please note that I’m not recommending that everyone should convert their Traditional IRA to a Roth IRA. There are many moving parts to the equation, and everyone’s situation is different.
The person doing your taxes knows your tax situation and would be the one to crunch the numbers to see if a conversion makes sense for you. The ability to convert continues beyond 2010, giving you the opportunity to do small amounts each year to keep your marginal tax rate lower. With the unpredictability of future tax rates, tax diversification could be the key. That way you will be right on either the portion you converted or the portion not converted.