Insights

Whether or not to convert a traditional IRA to a Roth IRA has been a question that many individuals have asked this year. Unfortunately, there is not a clear cut “yes” or “no” answer. There are many factors to consider before converting to a Roth IRA. Some of those factors are: 

• Income taxes due
• Income limitations
• Timing
• Full vs. partial conversion
• Possible benefits 

The best time to convert an IRA is when the account is down in value. Due to the recent bear market, many investors have experienced a significant drop in account value. This uncertainty and volatility in the markets creates both opportunities and problems.

One opportunity— taxes are based on the value of the account at the time of conversion, so if your IRA has depreciated, now might be a good time to convert all or a portion of your IRA assets. However, you might not be able to convert this year due to your modified adjusted gross income limits (MAGI). If your MAGI is higher than $100,000, you cannot convert in 2009. Again, making the conversion will require paying taxes on the amount converted. So the next question is: are you able to pay the taxes on the conversion with funds outside of the IRA? If not, you might want to reconsider converting. One of the issues with paying taxes from the converted IRA is the age restriction – if you are under 59 ½, the 10% early distribution penalty comes into effect. By paying the conversion tax from another source, you will have increased the effective size of your retirement account.

If you can’t convert this year due to income limits, there is always next year. In 2010, anyone can convert a traditional IRA to a Roth, because the $100,000 limitation does not apply. There is also a benefit for converting in 2010 – income can be reported over two years beginning with the 2011 tax year. How does that work? An individual who does a conversion in 2010 would report half the income on his 2011 return (paying taxes by April 15, 2012) and the second half on his 2012 return (paying taxes by April 15, 2013). The conversion itself would be reported in 2010 using Form 8606, but none of the income is reported for that year unless the individual opts out of this special rule. Timing a conversion is also important. Converting earlier in the year extends the time before taxes are due. Also, it offers you a longer opportunity to undo it if the investments go down in value. You can undo, or recharacterize, a Roth conversion by October 15 of the year after the conversion.

Are there any real benefits to converting? Yes, there are. Roth IRAs do not require you to make a withdrawal at age 70 1/2, thus no tax is paid on this income. Converting to a Roth IRA eliminates the need to take unwanted taxable distributions and allows the account to grow tax-free well into an individual’s 70s, 80s or 90s. It also puts you in control of your adjusted gross income each year. Distributions from a Roth IRA are not included in income, so they do not affect the amount of tax you pay on your Social Security benefits.

You should speak with your tax/financial advisor about the pros and cons of converting your traditional IRA to a Roth IRA. Furthermore, you’ll want to make sure it makes sense for your particular tax planning situation.

Ref: Kaye A. Thomas, 2009 Go Roth!

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