| Topic - Roth IRA: To Convert or Not | Education Center |
JUST BECAUSE YOU qualify to open a new Roth IRA doesn't mean you can convert your plain vanilla IRA into a Roth. Unfortunately, the income limits for conversion are lower than they are for opening new accounts -- $100,000 adjusted gross income for joint filers and singles. The other problem is that you have to pay taxes on the conversion. That can entail a big cash outlay -- cash you may or may not have at the moment.
But if you qualify -- and can afford the taxes -- you probably should convert for all the reasons we mentioned in Which IRA Is Right for You?. Among the issues you need to consider:
Do You Have the Cash?
This is the biggest hurdle to conversion. The problem: When you move your regular IRA to a Roth, you will have to pay taxes on any pretax contributions. And you have to pay right now. In 1998, Uncle Sam said you could spread the tax over four years by adding 25% of your rollover amount to your income each year. But no more. As of the 1999 tax year, you have to add the full amount you are rolling over to your income and pay tax on it in cash.
Technically, you could use some of the IRA money itself to pay the tax, but that's a bad idea. If you do, you will owe a 10% withdrawal penalty on that amount. Plus, you lose the opportunity for tax-free compounding of that principal.
And don't think that you can avoid the tax by just rolling over your after-tax contributions. Each dollar you roll over from your IRA is considered a "blended" dollar and taxed to the extent the entire account would be.
"If you have the money or can get it, you should try to convert, because you would eventually have to pay that tax anyway," advises Steven Corrick, a tax partner at Arthur Andersen in Washington, D.C. "In exchange for that, you get tax-free withdrawals from the accumulated earnings in that account."
Will the Rollover Disqualify You for Important Tax Benefits?
The conversion income could push you into a higher tax bracket and disqualify you from other tax benefits such as the new tuition tax credits.
Will Your Income Tax Bracket Drop After Retirement?
The clearest case in which converting from a tax-deductible IRA to a Roth IRA does not make sense is when you expect to drop into a lower income tax bracket after you retire. Why? You will have to pay income tax on the conversion at your current high rate. Instead, let the money compound in your old IRA and pay taxes at your lower rate in retirement.
How Much Time Do You Have Until Retirement?
Generally, the older you are, the less sense it makes to convert a traditional IRA to a Roth. You'll have less time to make up for what you lost in taxes on the conversion.
Do You Plan to Leave All of Your IRA to Your Heirs?
One case in which it makes sense for an older, traditional-IRA holder to transfer funds to a Roth IRA is when he or she is planning to leave the money to heirs. Why? Three reasons: First, unlike traditional IRAs, Roths require no minimum distributions during the life of the IRA owner or, upon his or her death, the life of his or her spouse. With a tax-deductible IRA, you must begin making withdrawals from that account at age 70 1/2, losing out on the chance for that money to continue compounding. That can mean a lot less money for your heirs. In an example from T. Rowe Price, a 65-year-old man who transfers $100,000 from his traditional IRA to a Roth IRA could leave a total of $822,358 to his spouse or children over time. Without the conversion, the most his heirs could receive is about half that.
Second, conversion to a Roth will reduce your taxable estate by the amount of tax you pay. This reduces estate taxes for your heirs.
Finally, if you missed the deadline for naming an IRA beneficiary (usually April 1, after the year you turn 70 1/2), you can convert to a Roth and then name a new beneficiary. This will enable your beneficiary, say your grandchild, to keep the IRA going during his or her expected life span (as calculated by the IRS). This maneuver is a boon for families who can cover income and estate taxes without dipping into the IRA.
Roth Scenarios
| CONVERSION SCENARIO | IRA ASSETS | TOTAL AFTER-TAX INCOME DURING DISTRIBUTION PERIOD WITH CONVERSION TO ROTH IRA | TOTAL AFTER-TAX INCOME DURING DISTRIBUTION PERIOD WITH TRADITIONAL IRA |
| 40-Year-Old in 28% Tax Bracket Pre- and Post-Retirement* | $25,000 | $302,078 | $248,251 |
| 50-Year-Old in 28% Tax Bracket Pre-Retirement and 15% Tax Bracket Post-Retirement* | $50,000 | $279,841 | $278,094 |
| 65-Year-Old in 28% Tax Bracket Seeking to Maximize Earnings for Heirs | $100,000 | $822,358 | $411,462 |
| Source: T. Rowe Price. Assumes the investor's AGI is less than $100,000, makes no additional IRA contributions, and has an 8% annual rate of return before retirement and a 7% annual rate of return after retirement. *Assumes the investor retires at age 65 and withdraws the money over a 20-year period. Assumes the investor retires at age 65, lets the assets accumulate until age 85 and then leaves the money to his heirs, who withdraw the money over 20 years. |
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