The buzz about Roth IRA conversions is getting louder. And why not? Beginning in 2010, the IRS eliminated the prior restriction that disallowed conversions for taxpayers with an adjusted gross income (AGI) above $100,000. Also, you can split the taxable income triggered by a 2010 Roth conversion evenly over 2011 and 2012. (You report 50% of the income in each of those years.)
But should you convert to a Roth? That’s another story.
Strategy: Crunch all the numbers. Don’t assume that a conversion is right for you just because you can do it for the first time. Also, if it makes sense, you might convert only part of your traditional IRA assets and leave the rest alone.
What’s in the pot at the end of the rainbow? Qualified distributions from a Roth (e.g., distributions after age 59½ and after having a Roth IRA in existence for more than five years) are federal-income-tax-free. Plus, you’re not required to take minimum distributions after age 70½ like you are with a traditional IRA. These future benefits offer plenty of incentive to convert to a Roth this year.
Example: Say the total of the assets in all your traditional IRAs is currently valued at $500,000. You’re 55 years old, married and you estimate that you’ll be in the 35% tax bracket in 2010.
You also expect to begin taking withdrawals from your IRA in 15 years when you will be in the 28% tax bracket. Assume a 6% annual rate of return on your IRA investments.
Using Bank of America’s Roth IRA Conversion Calculator, the estimated future value of your traditional IRAs in 15 years is $914,527. In contrast, if you convert to a Roth in 2010, the estimated future value is $950,092—or $35,565 more than if you leave the assets in your traditional IRAs.
On these facts, you will owe $175,000 in federal income tax in 2010 if you pay the full amount of the conversion tax liability this year. However, you can elect to defer the taxable income and spread it evenly over 2011 and 2012. This would result in a lower tax bill if your tax rate in those years goes down but a higher tax bill if it goes up. (You always have the option of reporting all the income from a 2010 conversion on this year’s return if that looks like the better deal.)
This scenario seems to indicate you should go full steam ahead with a conversion of 100% of your assets. But there are other variables to consider. For example:
- The calculation assumes that you’ll be paying the full amount of tax on the conversion with funds outside of your IRA. However, if you have to use some or all of the IRA assets to pay the tax piper, this will dilute or even wipe out the benefit of the conversion. In our example, you would be left with $825,614 if you had to pay the tax with IRA funds—$88,913 less than the amount you’d have if you left the IRAs alone.
- The numbers will also change if you’ve contributed to IRAs on a nondeductible basis. There’s no tax on the portion attributable to these contributions.
- Consider the impact of any state and local income taxes owed in addition to federal income tax. This is especially critical if you live in a high-tax state.
- The additional tax liability on the conversion could push you into a higher tax bracket. Conversely, if you delay the conversion until you’re in a lower tax bracket, you might benefit.
This doesn’t have to be an “all-or-nothing proposition.” A partial conversion may be preferable.
Let’s go back to our example. Suppose you can afford to pay the entire $87,500 tax out-of-pocket if you convert 50% of the traditional IRA balances, or $250,000. Thus, the Roth conversion will produce a net benefit of $17,783: $475,046 with a Roth compared to $457,263 with the traditional IRAs.
But, the payoff for a Roth conversion will be significantly greater if you don’t need to take any withdrawals. If your main objective is to preserve the biggest possible nest egg for your heirs, converting is almost a no-brainer. In the end, do what’s best for you.
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