Last year, all Individual Retirement Account (IRA) owners were given the opportunity to convert their traditional IRAs to Roth IRAs, regardless of income or filing status. Before then, owners of traditional IRAs with a modified adjusted gross income (AGI) of more than $100,000 or married filing separately, were prevented from making the conversion. The question now is whether it is a good deal to convert your traditional IRA to a Roth IRA or not.
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 (also known as RMDs) based upon IRS life expectancy tables. Upon your demise, the balance remains income taxable to your estate or beneficiaries.
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, 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 5-year requirement has been met).
There are various factors that go into making an informed decision, not so much from calculating the numbers, which is rather straightforward, but from the reasoning behind the numbers. The decision could have a major impact on your financial life, especially if the traditional IRA is a significant portion of your overall wealth.
Prudent analysis of the variable benefits and consequences will take into account your investment assets, long term goals, the need for income for longer life in retirement, anticipated tax increases, erratic financial markets and an uncertain global economy, all of which are moving targets.
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,) from the IRA account would decrease the funds available to grow tax-free in the Roth IRA.
• Think you will not need to spend your IRA assets during retirement and prefer to pass them to your beneficiaries, income tax-free.
• Expect the value of your IRA assets to grow significantly in the future, and wish to save 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.
• Believe your tax bracket will be the same or higher in later years, which could result in increased taxes on distributions from your traditional IRA.
Other planning considerations:
Although last year's tax change permits the higher income earners to convert any amount in existing IRAs to Roth IRAs, there are still income limitations on earners who can contribute new funds to a Roth IRA. However, there is a quirk in the law that allows those affluent earners to contribute to a non-deductible IRA, then convert that to a Roth IRA. This strategy could be considered as long as this tax loophole remains on the books.
You are allowed to convert only part of a traditional IRA to a Roth IRA if you wish, with the amount converted coming proportionately from deductible and non-deductible contributions if applicable. You cannot avoid income tax by converting only non-deductible amounts.
You and your spouse can also elect to convert multiple traditional IRAs.
If your Roth IRA declines 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 the lesser value to the Roth IRA, thus paying less tax than on the previous conversion, getting another "do-over".
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. Although there are Roth conversion calculators online, this would be a good time to consult your professional advisor to review the numbers with you, determine how the various strategies might work for you and recommend a course of action.
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 (also known as RMDs) based upon IRS life expectancy tables. Upon your demise, the balance remains income taxable to your estate or beneficiaries.
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, 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 5-year requirement has been met).
There are various factors that go into making an informed decision, not so much from calculating the numbers, which is rather straightforward, but from the reasoning behind the numbers. The decision could have a major impact on your financial life, especially if the traditional IRA is a significant portion of your overall wealth.
Prudent analysis of the variable benefits and consequences will take into account your investment assets, long term goals, the need for income for longer life in retirement, anticipated tax increases, erratic financial markets and an uncertain global economy, all of which are moving targets.
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,) from the IRA account would decrease the funds available to grow tax-free in the Roth IRA.
• Think you will not need to spend your IRA assets during retirement and prefer to pass them to your beneficiaries, income tax-free.
• Expect the value of your IRA assets to grow significantly in the future, and wish to save 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.
• Believe your tax bracket will be the same or higher in later years, which could result in increased taxes on distributions from your traditional IRA.
Other planning considerations:
Although last year's tax change permits the higher income earners to convert any amount in existing IRAs to Roth IRAs, there are still income limitations on earners who can contribute new funds to a Roth IRA. However, there is a quirk in the law that allows those affluent earners to contribute to a non-deductible IRA, then convert that to a Roth IRA. This strategy could be considered as long as this tax loophole remains on the books.
You are allowed to convert only part of a traditional IRA to a Roth IRA if you wish, with the amount converted coming proportionately from deductible and non-deductible contributions if applicable. You cannot avoid income tax by converting only non-deductible amounts.
You and your spouse can also elect to convert multiple traditional IRAs.
If your Roth IRA declines 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 the lesser value to the Roth IRA, thus paying less tax than on the previous conversion, getting another "do-over".
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. Although there are Roth conversion calculators online, this would be a good time to consult your professional advisor to review the numbers with you, determine how the various strategies might work for you and recommend a course of action.