As we approach the end of the year, we may wish to consider converting a traditional IRA to a Roth IRA. The ability to ultimately take tax-free withdrawals from a Roth IRA makes a conversion seem attractive. Nevertheless, that's a decision that has no "one size fits all" answer. All of us must analyze this option based on our individual circumstances. The conversion decision depends on a number of factors, including our tax rates today versus those of tomorrow, how we will pay the taxes due on the conversion, the size of our estates, and our plans for those estates.
As you know, funds in a traditional IRA may be transferred to a Roth IRA by single or joint income tax filers in any year their modified adjusted gross incomes (MAGI), exclusive of the sum being converted, is $100,000 or less. However, married persons who file separate returns instead of a joint return may not convert a traditional IRA to a Roth IRA. While there is no minimum or maximum amount that must be converted, on conversion any previously untaxed money in the traditional IRA must be declared as income, and it will be taxed at ordinary income tax rates. The conversion must be completed by Dec. 31 of the year concerned. Specific details regarding conversions may be found in IRS Publication 590 (Individual Retirement Arrangements).
Given the above, now is a good time of year to discuss the subject of conversions for two reasons. First, because we're late in the tax year, we now have a far clearer idea as to what our final annual income will be. That income will tell us whether we will be able to meet the MAGI limits for making a conversion. Second, assuming we meet the MAGI limits but have yet to convert, we still have time to complete that conversion before the end of the year.
Let's assume you are within MAGI limits and are now considering whether you should convert some or all of your traditional IRA money to a Roth IRA. Should you do so? After all, if you do convert and pay income taxes now, when you finally tap into your Roth IRA after retirement, all that money will come back to you free of income taxes. Sounds good, doesn't it?
If it does, start by running some numbers on some of the online calculators that examine this issue. Check out The Motley Fool conversion calculator here. Still, there's far more to the conversion decision than just the numbers. The subject of conversion is so personal that we must really take a hard look at our entire situation, understand the tax pros and cons, and realize that there may be other non-tax and even non-financial reasons to convert or not to convert. In addition, the conversion decision rests on a number of factors, such as your tax rates today versus those of tomorrow, how the taxes due on the conversion will be paid, the size of your estate, and your plans for that estate.
In general, you may wish to convert a traditional IRA to a Roth IRA if:
- You won't tap into the Roth IRA within five years and you expect to be in a higher tax bracket in future years. Paying the taxes now while you're in a lower income tax bracket should save you income taxes later.
- You meet the MAGI limits this year but don't expect to do so in future years. For those who don't need to tap into the Roth IRA for income and who wish to build an estate for heirs, this could be a great way to minimize the overall income tax burden to the family. Heirs would get the proceeds free of income taxes, and in the interim the proceeds could continue growing free of taxes.
- You can pay the income taxes due on the conversion without tapping into the traditional IRA money to do so, and you expect to be in the same or a higher income tax bracket in retirement. Run the numbers as I did, and you'll discover that under these two conditions converting to a Roth is the clear winner over leaving the money in a traditional IRA to be taxed later.
- You don't anticipate needing the IRA money to live on, and you wish to avoid the annual mandatory distributions required from a traditional IRA when you reach age 70 ½. Paying the taxes now will allow the money to grow tax-deferred through the years ultimately to be received by heirs tax-free later.
In general, a conversion may not be a good move when:
- You must use part of the traditional IRA money to pay the income taxes due because of the conversion. Not only does that reduce the amount remaining within the Roth for compounding purposes, it may also increase the sum due the government on conversion should an early withdrawal penalty apply for taking money from a traditional IRA before age 59 1/2.
- The added income for the year caused by the conversion affects items on your income tax return that are tied to adjusted gross income (AGI). For instance, adding the extra income from the conversion to your AGI could cause more of your Social Security payments to be taxed; a smaller itemized deduction for your medical expenses; a smaller itemized deduction for your miscellaneous expenses; and/or a phase out of your allowable total itemized deductions or personal exemptions. The conversion income may also affect some income tax credits, such as those for childcare expenses. All of these impacts would cause an increased income tax burden for the year.
- You expect to be in a lower income tax bracket in retirement than you are in now. In that case, you would be better off leaving the money in the traditional IRA. Otherwise, you would pay more in income taxes by converting today while you are in a higher income tax bracket.
- You think Congress will change the rules in the future and tax all growth in a Roth IRA anyway with no grandfather provision to exempt the earnings in existing Roth IRAs at the time such a change may be implemented. Personally, I find this a highly unlikely scenario. Nevertheless, some cynics believe most strongly a future Congress will take this step. In the unlikely event such an event occurs, then conversion today offers no distinct tax advantage.
As you can see from this discussion, there is no easy answer to the Roth IRA conversion question. All of us must examine this issue using our own set of circumstances to determine the pros and cons as they pertain to our situation. That's the only way we can make the decision that's best for us and for our families. Given that this tax year is fast coming to a close, now is the time to do so.
This article was first published on November 12, 2001. It has been updated.
The Motley Fool may be all about investors writing for investors, but Dave Braze is all about retirement. After all, he's tried it three times. Nevertheless, he still finds time to answer questions for subscribers to theRule Your Retirementnewsletter service.