Retiree Portfolio IRA Conversion Considerations

As the end of the year approaches, you might consider converting your traditional IRA to a Roth IRA. The ability to ultimately take tax-free withdrawals from a Roth IRA makes a conversion seem attractive. However, a conversion may not be in your best interest. The conversion decision depends on a number of factors, including your tax rate today versus tomorrow's, how you will pay the taxes due on the conversion, the size of your estate, and your plans for your estate.

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By David Braze (TMF Pixy)
November 12, 2001

Halloween had not yet arrived when I noticed Yuletide ads appearing on the tube and Christmas decorations popping up in the shopping malls. Are we really that close to the end of the year or are the merchants just rushing the season? I suspect the latter. Still, we are close enough to New Year's celebrations to let me address an issue that crops up from time to time: converting a traditional IRA to a Roth IRA.

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 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 can be found in IRS Publication 590.

Now is a good time of year to discuss the subject of conversions for two reasons. First, because the year is drawing to a close, you should have a good idea as to what your final annual income will be, and thus your eligibility to convert. Second, assuming you meet the MAGI limits but have yet to convert, you still have time to complete that conversion before the end of the year.

But what happens if you made a conversion earlier in the year but discover later that you will exceed the MAGI limit of $100,000? Fortunately, there is a way to correct such a failed conversion provided you act by Oct. 15, 2002. For details, see this excellent article penned by my colleague, Roy Lewis, as well as IRS Publication 590.

Let's assume you are within MAGI limits, though, and are 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?

Yep, it sure does. Still, there's far more to the conversion decision than income taxes. I wrote about some of the tax issues involved earlier this year in this article, so I won't repeat the math here. But as I pointed out then, the subject of conversion is so personal that you must take a hard look at your 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 rate today versus tomorrow's, how the taxes due on the conversion will be paid, the size of your estate, and your plans for your 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. As discussed in my earlier article, using other resources to pay the taxes due establishes the Roth IRA as a clear winner as compared to leaving the money in a traditional IRA.

• 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 1/2. 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, 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 affects items on your income tax return that are tied to adjusted gross income (AGI). For instance, adding the extra income due to 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. It may also affect some income-tax credits, such as those for childcare expenses. All of these would cause an increased income tax burden for the year.

• You expect to be in a lower income tax bracket in retirement. 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 believe Congress will change the rules in the future by taxing all growth in a Roth IRA anyway while allowing no exemption on 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 that a future Congress will take this step. In the unlikely event such an event occurs, then conversion today offers no tax advantage.

That's it until next week. In the meantime, post away on the Retirement Investing or Retired Fools boards.

Best to all...Pixy

The Motley Fool may be all about investors writing for investors, but Dave Braze is all about retirement. After two more columns and 18 days, he's outta here. We hope the door doesn't hit him in the rear on his way out.