Why Now's the Time to Convert to a Roth IRA
Why would you want to convert to a Roth? First, a little background on the two types of IRAs. A traditional IRA lets you make tax-free contributions to a savings account, but then you must pay regular income tax when you withdraw the money and any interest it has earned. With a Roth IRA, in contrast, you contribute after-tax dollars. But all of your withdrawals from a Roth are tax-free.
Because all of the earnings in the account accumulate tax-free, a Roth is a better deal than a traditional IRA. In addition, a traditional IRA requires you to take minimum distributions from the account when you turn 70.5 years old, but you never have to take any money out of a Roth, meaning you can leave it tax-free to heirs.
Unique Options Available Only Now
Why is 2010 so great for Roth conversions? Two counts, really. For one thing, Congress finally removed the upper-income limit on doing conversions. Until now, if you had adjusted gross income of more than $100,000, you didn't qualify. But starting this year, you can make the conversion no matter what your income level.
The other great advantage is that if you make the conversion before year-end, Congress has given you some unique options. You can take the money from the traditional IRA conversion as income in 2010 and pay the tax owed, which some tax advisers are counseling because taxes are likely to go up next year.
But you also have the option of taking the income and dividing it between 2011 and 2012, so you'll have to pay tax on only half the total amount each year. So if you converted a $100,000 traditional IRA in 2010, you could take it as $50,000 in income in 2011 and $50,000 in 2012.
Does Age Matter?
How to decide whether it's advantageous to make the conversion? Casey Mervine, a financial consultant at Charles Schwab in Torrance, Calif., says there are lots of factors to consider. But it really comes down to how long you have to earn back the money you must pay in taxes up-front.
"With the compounding you have over 20 years, it gets much more advantageous when you calculate the numbers for a person who is younger than for someone who is older," Mervine says. So, a 40-year-old is likely to earn much more than a 60-year-old, offsetting the tax.
But James Lange, a certified public accountant in Pittsburgh and the author of The Roth Revolution: Pay Taxes Once and Never Again, says converting can also be advantageous for people older than 60. "It is a huge misconception that older IRA owners shouldn't make the conversion," Lange says. "I often recommend Roth IRA conversions to retirees and seniors."
Lange says the key question is not how much you have in total dollars, but how much you have in purchasing power.
He gives the following example: An investor has $100,000 in a traditional IRA and $25,000 in the bank. If he takes the money out of the IRA and uses the $25,000 to pay the taxes due, he is left with $100,000 to spend. But if he converts the traditional IRA to a Roth IRA using the same funds, he will be left with $100,000 in an account that generates income tax-free forever.
"It doesn't matter if the person is 40-years-old or 60 or even 80, I can prove mathematically that given reasonable assumptions over time, the person who makes the conversion to a Roth IRA is going to have more purchasing power than someone who doesn't," Lange says.
Still, Lange says, conversions aren't for everyone, especially people whose incomes are likely to go down in the years ahead or for someone who needs to spend the money in the near future.
Convert Your 401(k), Too
Mervine points out that a conversion makes sense only for investors who have sufficient money outside the IRA account to pay the taxes due. For example, if a 40-year-old converts a $50,000 in a traditional IRA to a Roth and uses IRA funds to pay the taxes due, he'll have to pay taxes not only on the $50,000 withdrawal but also on the $15,000 withdrawn to pay the taxes. In addition, there's a 10% penalty for early withdrawal on the money used to pay the tax.
Another interesting development in 2010 is that Congress last month for the first time allowed for converting traditional 401(k) savings accounts held at employers to Roth 401(k)s. The same logic applies to these accounts: Given the widespread expectation that taxes will increase next year, making the conversion this year could save substantial money.
For example, if you're in the top tax bracket of 35% and you convert a $1 million 401(k) this year, you'll pay $350,000 in taxes. But if you wait until 2011 and the top tax rate goes up to 39.6% -- as is currently scheduled when the Bush tax cuts expire -- then you 'd pay $396,000, or $46,000 more.
Just another reason to consider converting to a Roth retirement fund this year. Psst, it's nearly November.