Converting to a Roth IRA

Starting in 2010, the income restrictions will go away.
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Editor's note: As a special feature for April, TheStreet.com is offering a seven-part series on maximizing your IRA. This installment is Part 2. Click here for Part 1, Part 3, Part 4, Part 5, Part 6 and Part 7.

Let's assume that you like the idea of saving for retirement and using a tax-deferred or tax-free method of doing so. Let's further assume that you are married, that you and your spouse are both around 40 years old, and that your total income is less than $150,000 per year. Which IRA, traditional or Roth, would be better?

First we'll discuss the basic differences. Contributions to a traditional IRA are tax-deductible in the year made. That means that our hypothetical couple can reduce their adjusted gross income by $8,000 by making the maximum contributions to their individual IRAs. If they are in the 25% tax bracket, then they will save one-quarter of the total contributed, or $2,000, on their taxes due for the year. Therefore, in addition to that savings, they only need $6,000 to fund their contributions.

There are a couple of negatives here, however. Uncle Sam requires that taxes be paid eventually and, in the case of the traditional IRA, these taxes will be paid when withdrawals are made, usually in retirement years over the age of 59 1/2. There are penalties associated with making early withdrawals (usually 10% of the amount withdrawn), but these penalties are waived in certain circumstances, such as the taxpayer becoming disabled, various financial calamities or when the withdrawal is being used to make a first-time home purchase.

Also, at age 70 1/2, withdrawals are mandated on a schedule that roughly coincides with standard mortality life-expectancy tables.

The Roth IRA reverses the timing of tax liability for the contributions and withdrawals. Contributions are not deductible in the year made. So our couple would need to have $8,000 available to make the maximum contribution. But the huge advantage of a Roth IRA, especially for younger people, is that withdrawals are not subject to tax. Over a period of 20 years, the $8,000 contribution could easily appreciate to $25,000 at a 6% rate of return. None of that amount would be subject to tax.

There are still penalties associated with early withdrawals, but those penalties are only assessed on the earnings withdrawn -- not the original contributions. There are also penalties on any withdrawals made during an initial five-year holding period. However, there are no age-related withdrawal requirements, so assets can continue to grow tax-free for life and then will pass to heirs. While the Roth IRA is part of the estate and may trigger estate taxes, the beneficiary of a Roth IRA can avoid any income taxes by following very simple rules.

Clearly, to me at least, the Roth IRA is the preferred vehicle for most people and especially for younger investors. However, there are lots of variables to be considered, including current tax rates, future tax rates and the age of the investors. And, as a practical matter, availability of capital to invest has to be considered.

In most cases, I would rather maximize a contribution to a traditional IRA than invest a smaller amount in a Roth IRA. For that reason, and also because I like to take my tax breaks now rather than later, my own personal IRA is currently totally a traditional IRA. I'm expecting, though, that I may have a future opportunity to have the best of both worlds by converting my traditional IRA into a Roth IRA.

Converting to a Roth IRA

The ramifications of converting a traditional IRA into a Roth IRA are complex and different for each individual. There are a couple of constants, however. First, we know that taxes on the amount converted will be due immediately. If those taxes must be paid from the amount withdrawn from the traditional IRA, it is almost impossible to make a case for conversion unless there is a lengthy time between conversion and retirement to make up the taxes paid.

However, if assets are available from other sources to pay the tax bill, a conversion makes much more sense. Conversion is even more attractive if tax rates in retirement are the same or higher than current rates. While it may seem unlikely that your tax rate will be higher in retirement than while you are working, inheritances could boost the size of your investment portfolio substantially. Also, let's not forget, politicians who insist on growing the government instead of the economy have a way of increasing tax rates whenever possible.

There is an income restriction on IRA conversions. Currently, adjusted gross income must be less than $100,000 (not including the conversion amount) before a conversion is allowed. Fortunately, there is good news on this limitation due to last year's tax bill. Starting in 2010, this limitation will no longer apply, and conversions that occur in 2010 will be able to have half of the taxable converted amount taxed in 2011 and the other half taxed in 2012.

Personally, because my earned income is low and most of my other income is capital gains, I might get an opportunity to convert my own traditional IRA into a Roth if the market goes against me for a year, thus keeping my taxable income at a low level. It should be noted that, in order to avoid any penalties, assets have to be held in a Roth IRA for at least five years after conversion.

Coming up next: Part 3 will discuss withdrawals from IRAs and the potential penalties involved.