Retirement savings held in a tax-deferred, traditional IRA may be converted to a tax-exempt, Roth IRA. IRS tax law determines eligibility for a conversion, but the more important question is whether a conversion provides sufficient financial benefit.
To be eligible to make a Roth IRA conversion, the taxpayer’s modified adjusted gross income (AGI) must be $100,000 or less, and the taxpayer cannot be married filing separately. Modified AGI does not include the amount being converted to a Roth IRA. An important exception to the AGI limit occurs in year 2010. During 2010, taxpayers with incomes above $100,000 are also eligible to make Roth IRA conversions.
A Roth IRA conversion is essentially a withdrawal from a Traditional IRA and a matching addition to a Roth IRA. When money is withdrawn from a Traditional IRA, ordinary income taxes must be paid on the amount withdrawn. Penalty taxes of 10% normally apply to Traditional IRA withdrawals if made before age 59½. The 10% penalty does not apply if the total withdrawal amount is rolled over to a Roth IRA within 60 days, known as a conversion contribution.
Ordinary income taxes will be due on the amount of the Roth IRA conversion. Taxes can be paid from money held within the IRA or money held outside of the IRA in a taxable account. If money is withdrawn from the IRA to pay taxes, that money will not be converted to the Roth IRA, and therefore, subject to a 10% penalty tax if the taxpayer is younger that age 59½. If a taxpayer under age 59½ must use money within an IRA to pay the income taxes on the conversion, the conversion should not be made.
When taxpayers make Roth IRA conversions, they are electing to pay income taxes now rather than later. The benefit of this decision differs on a case by case basis. The Roth IRA conversion may not be a good choice for taxpayers in a high marginal tax bracket who expect to be in a lower marginal tax bracket during retirement. Making a Roth IRA conversion while in a high tax bracket would cause them to pay more taxes now than they would otherwise pay by waiting until retirement when in a lower tax bracket.
Roth IRA conversions become more attractive for taxpayers who expect to be in a similar or higher marginal tax bracket during retirement. This may be based on an expectation of having more income in retirement or a prediction that income tax rates will be higher in the future than they are currently. If a taxpayer expects to be in a higher tax bracket in the future, making a Roth IRA conversion and paying lower taxes now is favorable compared to taking withdrawals in the future when tax rates are higher.
An evaluation of the Roth IRA conversion may require highly uncertain assumptions about future income tax rates. However, making those assumptions will allow for an estimation of the financial benefit of a Roth IRA conversion. Three income tax rates need to be assumed: the tax rate in the year of conversion, the tax rate during the years after conversion but before retirement, and the tax rate during the years after retirement.
The income tax rate in the year of the Roth IRA conversion can be affected by the amount of the conversion, as a large conversion amount may place the taxpayer into a higher marginal tax bracket. The tax rate in the year of conversion is very important in the evaluation because it affects the upfront tax cost of the Roth IRA conversion. For example, a taxpayer is normally in the 25% marginal tax bracket, but a conversion of $100,000 increases the taxable income and places the taxpayer in the 28% bracket. The cost of the conversion can be estimated as 28% of $100,000, which equals $28,000 of taxes due.
Continuing the example, an evaluation of the Roth IRA conversion would compare the financial benefit of $100,000 in a Roth IRA versus $100,000 in a Traditional IRA plus $28,000 in a taxable account. The taxable account holding represents the amount of taxes saved by not making a conversion. All three amounts are assumed to grow until retirement, with the Roth IRA and Traditional IRA growing at a before-tax rate and the taxable account growing at an after-tax rate.
Once retirement is reached, the evaluation compares the available withdrawal from the Roth IRA versus the available withdrawals from the Traditional IRA and taxable account. The withdrawal from the Traditional IRA is reduced by the amount of ordinary income taxes due. For example, if the IRA withdrawal is $30,000 and the taxpayer is in the 25% tax bracket, the withdrawal is reduced by $7,500, which nets to $22,500. After each year of withdrawals, the remaining balances continue growing, with the taxable account at an after-tax rate, until the accounts are fully depleted.
In comparing the results, the Roth IRA conversion proves to be beneficial if the available withdrawal from the Roth IRA is greater than the after-tax withdrawal from the Traditional IRA plus the withdrawal from the taxable account. If the after-tax withdrawals from the Traditional IRA and taxable account are greater than the available Roth IRA withdrawal, the conversion would not be beneficial. Remember this evaluation is largely dependent on uncertain tax rates, so the results should not be interpreted as definite, especially if the margin of benefit is small.
This example evaluation of a Roth IRA conversion ignores any outside factors assumed in an individual’s overall financial plan. Advisement from a financial professional is highly recommended before attempting a Roth IRA conversion. The circumstances of each person’s financial situation will determine if a Roth IRA conversion provides financial benefit or financial detriment to his or her specific financial plan.
