Come January, a longstanding rule that has prevented many people from enjoying the benefits of Roth IRAs will be lifted. Anyone, regardless of income, will be able to convert a traditional IRA into a Roth, allowing investments to grow tax-free.
This option is worth thinking about now, because you may have to come up with a substantial chunk of cash to pay taxes triggered by the conversion.
It sounds great, but the Roth conversion doesn’t make sense for everyone. Key factors are your age, tax bracket, time before you’ll start IRA withdrawals, and available cash to pay tax on the conversion.
The BankingMyWay.com Roth IRA Conversion Calculator can help you decide whether this move makes sense.
Millions of Americans have traditional IRAs, funded from direct investments or rollovers from 401(k)s and similar workplace retirement plans.
Depending on your income and whether you have a retirement plan at work, your contributions to traditional IRAs may or may not be tax deductible. Once in the account, your money grows on a tax-deferred basis, meaning you pay no tax until it is withdrawn.
Roth IRAs do not provide any tax deduction on contributions, but all withdrawals are tax free. That makes them tremendously attractive to many investors, especially those who do not qualify for deductions on traditional-IRA contributions anyway.
But there’s a catch: Individuals with modified adjusted gross incomes above $120,000, and couples who file joint returns with MAGI more than $176,000 cannot contribute. Also, taxpayers, whether single or married, cannot convert traditional IRAs to Roths if their MAGI exceeds $100,000.
(For details on Roths and a definition of MAGI, see IRS Publication 590.)
This $100,000 limit will be waived for conversions done during 2010.
Unfortunately, investors who convert must pay income tax as if they were withdrawing money from their traditional IRA. Deciding whether to convert boils down to figuring whether it’s cheaper to pay taxes in the present or to keep the traditional IRA and pay in the future. People who convert in 2010 can either pay the tax in that year or pay half in 2011 and half in 2012.
By converting and paying in 2010, you would avoid tax on future investment gains. But the money you spend on taxes will not be available to invest, trimming those gains.
The brokerage firm Charles Schwab (Stock Quote: SCHW) breaks the decision down to a series of steps described in the firm’s On Investing magazine for customers.
First, do you expect that in retirement your tax bracket will be at least as high as it is now? If the answer is “no,” a conversion probably doesn’t make sense, because you’d pay tax on the converted sum at today’s high rate when you could pay at a lower rate later by sticking with the traditional IRA.
Second, will you be able to avoid withdrawing your IRA funds for at least next five years? A five-year rule can affect the tax-free status of future withdrawals. And Schwab argues you need a longer time horizon for the Roth’s tax-free earnings to make up for the taxes paid for the conversion. So, again, if the answer is “no,” a conversion probably doesn’t make sense.
Finally, do you have enough cash in other accounts to pay the conversion tax? Paying the tax with funds withdrawn from the traditional IRA could leave the Roth substantially smaller, stunting future gains. If the answer is “no,” don’t convert.
The conversion calculator takes into account the gains that might be enjoyed if there were no conversion and cash was invested instead of being used to pay a conversion tax. In many cases, this would be more profitable than converting to a Roth.
—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.