“To be, or not to be…..that is the question”
From “Hamlet”
~William Shakespeare, 1602
Starting in 2010, all IRA owners have the opportunity to convert their traditional IRAs to Roth IRAs, regardless of income or filing status. Before this year, owners of traditional IRAs with a modified adjusted gross income (AGI) over $100,000, or married filing separately, were prevented from making the conversion. The big question now is whether it is a good deal to convert your traditional IRA to a Roth IRA or not.
Although the ultimate decision doesn't have the dire implications as it did for Hamlet, the result could have quite a major impact throughout your financial lifetime, especially if the traditional IRA is a significant portion of your overall wealth. There will be plenty of anguish and gnashing of teeth on your way to making an informed decision — not so much from calculating the numbers, which is rather straightforward — but from the reasoning behind the numbers.
Prudent plotting of the variable benefits and consequences will take into account your investment assets, long-term goals, the need for income for the rest of your life, anticipated tax increases, erratic financial markets and an uncertain global economy. Do you see the moving targets? This decision shouldn't be made hastily or without an overall analysis of your current and future financial situation, including all assets, income expectations and family considerations. Although there are Roth conversion calculators online, this would be a good time to consult your professional advisor to work through the numbers with you and the nuances of various strategies.
Why consider converting?
With some exceptions, your traditional IRA consists of tax-deductible contributions that grow tax-deferred with distributions taxed as ordinary income. At age 70 you generally have to begin taking annual required minimum distributions (RMDs) based upon IRS life expectancy tables, and upon your demise the balance remains income taxable to your estate or beneficiaries. Simplified Employee Pension (SEP) IRAs can be converted as well as SIMPLE IRAs, which require a two year holding period before conversion.
Your Roth IRA consists of after-tax (non-deductible) contributions that are available to withdraw any time, with earnings that grow tax-free. Distributions are tax-free if qualified — those made following the fifth year from the first contribution to an account owner at least 59 1/2, or due to death, disability or for first-time home purchase expense (up to $10,000 lifetime limit). Distributions are not required, allowing the assets to continue to grow tax-free, and upon your demise the balance passes income tax-free; however, your beneficiaries will have to take required minimum distributions (tax-free if the five-year requirement had been met).
Are income taxes due on
conversions?
Upon conversion to a Roth IRA, deductible contributions and earnings in the traditional IRA become income taxable, however the 10-percent penalty does not apply for those under age 59 1/2. If the conversion is completed in 2010, a special rule allows you to split the income ratably over 2011 and 2012, thus paying the taxes over two years. You can elect to declare all the income from the conversion in 2010 and pay the taxes due in one year — an interesting consideration with income taxes certain to increase.
Who should consider converting
to a Roth IRA?
As mentioned, whether a conversion works for you depends on numerous factors, all pertinent to your personal situation. However, generally, a Roth IRA could be beneficial if you:
• Have non-IRA assets to pay the income taxes on the conversion, as paying taxes (and penalty if under 59 1/2) from the IRA account would decrease the funds available to grow tax-free in the Roth IRA
• Believe you will not need to spend your IRA assets during retirement and wish to pass them to your beneficiaries, income tax-free
• Expect the value of your IRA assets to grow significantly in the future, thus saving taxes on the appreciation for you or your beneficiaries
• Have some time before you anticipate retiring or have need of the funds, as generally the longer you delay distributions, the more you benefit
• Think your tax bracket will be the same or higher in later years, resulting in increased taxes on distributions
What about partial conversions or multiple accounts?
You are allowed to convert only part of a traditional IRA. However if the account contains non-deductible contributions the amount converted will be deemed to come partly from non-deductible contributions and partly from deductible contributions and earnings. You cannot avoid income tax by converting only non-deductible amounts.
You and your spouse can elect to convert some or all of your traditional IRAs.
What if the Roth IRA drops
in value after I convert from
traditional IRA?
If the account goes down in value following conversion, by recharacterizing, or undoing the transaction, you can avoid paying income tax on the conversion value if certain tax law requirements are met. You get a do-over. And if you meet special timing rules, you could then reconvert to the Roth IRA thus paying less tax than on the previous conversion. You get another do-over.
Some additional planning
considerations:
Choosing to significantly bump up your taxable income in one or two years could have unintended consequences. The increased income could result in your Social Security income being taxed (if you are taking payments). In some cases, a higher AGI could limit deductions and credits you were able to claim at lower thresholds. You might be required to pay estimated taxes on increased income. Requests for college scholarships and financial aid could also be affected. You might consider making a charitable contribution that would produce an attractive tax deduction to offset the higher income.
This overview is not meant to be all inclusive and although converting to a Roth IRA might be attractive for you, there are pitfalls, and you want to be very careful to follow the rules precisely and allow plenty of time to complete the transaction. I recommend you seek professional advice to determine if a Roth IRA conversion is suitable for you and the best course of action.
From “Hamlet”
~William Shakespeare, 1602
Starting in 2010, all IRA owners have the opportunity to convert their traditional IRAs to Roth IRAs, regardless of income or filing status. Before this year, owners of traditional IRAs with a modified adjusted gross income (AGI) over $100,000, or married filing separately, were prevented from making the conversion. The big question now is whether it is a good deal to convert your traditional IRA to a Roth IRA or not.
Although the ultimate decision doesn't have the dire implications as it did for Hamlet, the result could have quite a major impact throughout your financial lifetime, especially if the traditional IRA is a significant portion of your overall wealth. There will be plenty of anguish and gnashing of teeth on your way to making an informed decision — not so much from calculating the numbers, which is rather straightforward — but from the reasoning behind the numbers.
Prudent plotting of the variable benefits and consequences will take into account your investment assets, long-term goals, the need for income for the rest of your life, anticipated tax increases, erratic financial markets and an uncertain global economy. Do you see the moving targets? This decision shouldn't be made hastily or without an overall analysis of your current and future financial situation, including all assets, income expectations and family considerations. Although there are Roth conversion calculators online, this would be a good time to consult your professional advisor to work through the numbers with you and the nuances of various strategies.
Why consider converting?
With some exceptions, your traditional IRA consists of tax-deductible contributions that grow tax-deferred with distributions taxed as ordinary income. At age 70 you generally have to begin taking annual required minimum distributions (RMDs) based upon IRS life expectancy tables, and upon your demise the balance remains income taxable to your estate or beneficiaries. Simplified Employee Pension (SEP) IRAs can be converted as well as SIMPLE IRAs, which require a two year holding period before conversion.
Your Roth IRA consists of after-tax (non-deductible) contributions that are available to withdraw any time, with earnings that grow tax-free. Distributions are tax-free if qualified — those made following the fifth year from the first contribution to an account owner at least 59 1/2, or due to death, disability or for first-time home purchase expense (up to $10,000 lifetime limit). Distributions are not required, allowing the assets to continue to grow tax-free, and upon your demise the balance passes income tax-free; however, your beneficiaries will have to take required minimum distributions (tax-free if the five-year requirement had been met).
Are income taxes due on
conversions?
Upon conversion to a Roth IRA, deductible contributions and earnings in the traditional IRA become income taxable, however the 10-percent penalty does not apply for those under age 59 1/2. If the conversion is completed in 2010, a special rule allows you to split the income ratably over 2011 and 2012, thus paying the taxes over two years. You can elect to declare all the income from the conversion in 2010 and pay the taxes due in one year — an interesting consideration with income taxes certain to increase.
Who should consider converting
to a Roth IRA?
As mentioned, whether a conversion works for you depends on numerous factors, all pertinent to your personal situation. However, generally, a Roth IRA could be beneficial if you:
• Have non-IRA assets to pay the income taxes on the conversion, as paying taxes (and penalty if under 59 1/2) from the IRA account would decrease the funds available to grow tax-free in the Roth IRA
• Believe you will not need to spend your IRA assets during retirement and wish to pass them to your beneficiaries, income tax-free
• Expect the value of your IRA assets to grow significantly in the future, thus saving taxes on the appreciation for you or your beneficiaries
• Have some time before you anticipate retiring or have need of the funds, as generally the longer you delay distributions, the more you benefit
• Think your tax bracket will be the same or higher in later years, resulting in increased taxes on distributions
What about partial conversions or multiple accounts?
You are allowed to convert only part of a traditional IRA. However if the account contains non-deductible contributions the amount converted will be deemed to come partly from non-deductible contributions and partly from deductible contributions and earnings. You cannot avoid income tax by converting only non-deductible amounts.
You and your spouse can elect to convert some or all of your traditional IRAs.
What if the Roth IRA drops
in value after I convert from
traditional IRA?
If the account goes down in value following conversion, by recharacterizing, or undoing the transaction, you can avoid paying income tax on the conversion value if certain tax law requirements are met. You get a do-over. And if you meet special timing rules, you could then reconvert to the Roth IRA thus paying less tax than on the previous conversion. You get another do-over.
Some additional planning
considerations:
Choosing to significantly bump up your taxable income in one or two years could have unintended consequences. The increased income could result in your Social Security income being taxed (if you are taking payments). In some cases, a higher AGI could limit deductions and credits you were able to claim at lower thresholds. You might be required to pay estimated taxes on increased income. Requests for college scholarships and financial aid could also be affected. You might consider making a charitable contribution that would produce an attractive tax deduction to offset the higher income.
This overview is not meant to be all inclusive and although converting to a Roth IRA might be attractive for you, there are pitfalls, and you want to be very careful to follow the rules precisely and allow plenty of time to complete the transaction. I recommend you seek professional advice to determine if a Roth IRA conversion is suitable for you and the best course of action.