Converting to a Roth IRA
Are you considering converting to a Roth IRA?
And if you are, is it a good idea?
That's a great question.
When the 2010 Roth IRA conversion rules eliminate the $100,000 income limit on Roth conversions, legions of financial advisors will pressure their clients to convert their old 401k's, Traditional IRA's, and other retirement savings accounts into Roth IRA's.
And if you're one of those clients, you need to know if it's a good idea for you. So, let's find out!
First, make sure you understand the implications of converting by brushing up on the Roth IRA conversion rules.
Once you know for sure that you're eligible, and you think converting might be a good idea, here's a list of factors you need to consider...
Generally speaking, the state of your personal financial situation in relation to these five issues should answer the question of whether or not converting to a Roth IRA is a good idea.
So let's take a closer look at each one...
Paying Your Conversion Taxes
Whether it's your 401k, Traditional IRA, or other retirement savings plan, converting to a Roth IRA is a taxable event.
Unless you made non-deductible contributions to those plans, you're probably going to owe income taxes on the full amount of your conversion.
And how you pay that tax bill goes a long way in determining whether or not converting to a Roth IRA is a good idea.
You really only have two methods for paying your conversion taxes. You can pay with...
If you pay your tax bill with conversion funds, two things happen:
1) If you're under age 59 ½, you incur a 10% early withdrawal penalty on any portion of the conversion funds you use to pay your conversion taxes.
2) Any amount you use to pay your taxes doesn't end up in your Roth IRA, where funds grow tax-free until retirement.
If you pay your tax bill with funds from your current income or your personal savings, then all of the funds you convert end up in your Roth IRA.
Do you see the enormous benefit here?
Yes, you're paying a big tax bill out of your own pocket. But you're also moving funds from an account where withdrawals after age 59 ½ are fully taxable to a Roth IRA where withdrawals after age 59 ½ are NOT taxed.
Need an example?
Let's say you're 50 years old with a 401k worth $400,000, and you're in the 25% tax bracket. In this scenario, converting to a Roth IRA leaves you with a $100,000 tax bill.
But what if you don't have an extra $100,000 sitting around?
If that's the case, the only way you can convert is if you use some of the funds in your 401k to pay the tax bill.
If you do that, you end up with $300,000 in your Roth IRA, instead of $400,000, because the remaining $100,000 went to pay your tax bill, but...
It's not that simple. (It never is. Is it?)
Because you used that $100,000 to pay your tax bill instead of funding your Roth IRA, it's subject to a 10% early withdrawal penalty (since you're under age 59 ½).
So that's another $10,000 you owe the IRS.
Don't have $10,000 either?
Well, you can use conversion funds to pay that bill too. But then you end up with only $290,000 in your Roth IRA, and you incur another 10% early withdrawal penalty on that $10,000. That means you need to come up with another $1,000.
Do you see the problem here?
While it may not always be feasible to pay your conversion tax bill with personal savings or current income, it makes converting to a Roth IRA much easier and a lot less costly in the long-run.
Because more of your money ends up in your Roth IRA, where you never have to pay taxes on those funds again (assuming you wait until retirement).
Let's go back to the above example...
Assume you do have $100,000 in personal savings, and you use those funds to pay your Roth IRA conversion taxes. What's the end result?
A Roth IRA worth $400,000.
And a $400,000 Roth IRA is worth a lot more than a $400,000 401k, because the former is tax-free, while the latter is taxed every time you make a withdrawal.
So if you're converting to a Roth IRA, do everything within your means to pay your tax bill without using conversion funds. Once that money is in your Roth IRA, you never have to worry about taxes again... So your goal should be to get as much money as possible into your Roth IRA!
Your ability to pay conversion taxes out-of-pocket goes a long way toward answering the question of whether or not converting to a Roth IRA is a good idea.
Avoiding Future Taxes
If you're considering converting to a Roth IRA, one of the best reasons to do so is that Roth IRA withdrawals after age 59 ½ are usually tax-free and penalty-free.
Since your Roth IRA is funded with non-deductible (after-tax) contributions, those funds aren't subject to further taxation as long as your account meets the provisions of the 5 year rule and you've reached the age of 59 ½.
While a number of retirement accounts feature tax-free investment growth, most require you to pay taxes on your investment gains when you withdraw them. But with a Roth IRA, you can withdraw those funds tax-free.
So converting to a Roth IRA helps you avoid future taxes.
Need an example?
Let's say you and your spouse both have a Traditional IRA with a $50,000 balance and both accounts are invested in the same index fund. However, you decide converting to a Roth IRA makes sense, while your spouse chooses to stick with the Traditional IRA.
You pay your conversion taxes out-of-pocket and end up with $50,000 in a Roth IRA.
Since both accounts remain fully invested in the same index fund, you both end up with $200,000 at the age of 60.
If your spouse decides to withdraw funds, those funds are subject to income tax. But because your funds are in a Roth IRA, your withdrawals are tax-free.
So, even though both accounts have the same balance of $200,000, they really don't because one is tax-free and the other is not.
That's a very good reason why you should consider converting to a Roth IRA.
Avoiding Forced Distributions
Another benefit of converting to a Roth IRA?
Avoiding forced distributions.
Most retirement savings plans, including your 401k and Traditional IRA, require participants to start taking annual distributions at age 70 ½.
But what if you don't need to take a distribution? What if your expenses are fully covered without having to dip into your 401k or your Traditional IRA?
In such a case, aren?t you better served if your money continues to grow tax-free until the day you do need it?
That's one reason converting to a Roth IRA makes sense. Your Roth IRA doesn't require mandatory withdrawals at an arbitrarily chosen age.
You can withdraw funds at age 70 or not even touch your account until age 100. The choice is yours. In fact, if you have earned income, you can still contribute to a Roth IRA at any time, even after age 70 ½.
You just don't have that type of flexibility with other retirement savings plans. So if you want to avoid forced withdrawals, consider converting to a Roth IRA.
Converting to a Roth IRA needs to be a top priority when it comes to estate planning.
For many of the same reasons previously discussed... No mandatory distribution age and tax-free withdrawals.
Both provide you with the ability to leave more to your heirs.
For instance, if you don't need to withdraw funds from your Roth IRA at age 70 ½, you can leave those funds to grow tax-free for as long as you like. Then, if you die at age 80, your spouse can inherit a much larger retirement savings account than if you had been forced to withdraw funds at age 70 ½.
In addition, converting to a Roth IRA reduces your taxable estate by the same amount of income tax you pay to convert. This reduces estate taxes for your heirs.
As a result, any non-spouse beneficiary who inherits your Roth IRA can usually withdraw all of the funds from the Roth IRA without having to pay taxes. Why "usually"? Because in order for the withdrawal to be completely tax-free, your account must meet the provisions of the Roth IRA 5 year rule.
Once that's met, all Roth IRA withdrawals on behalf of your beneficiaries are tax-free and penalty-free, regardless of whether or not you reached the age of 59 ½ before you passed away.
But your 401k? Your Traditional IRA? Withdrawals from both are subject to taxation, even in the event of your death.
So if you don't see yourself in dire need of the funds in your 401k or Traditional IRA once you retire, and you?d like your spouse and/or children to inherit as much as possible, then you might want to consider converting to a Roth IRA.
Going From a Higher to a Lower Tax Bracket
When does converting to a Roth IRA NOT make sense?
The most clear cut case is when you're in a high income tax bracket now, but you plan to be in a much lower tax bracket during retirement.
In such a case, you end up paying more in taxes to convert than you otherwise would if you waited to withdraw those same funds during retirement.
For instance, let's say you're a 54 year old executive manager with a $400,000 Traditional IRA, and you're currently in the 35% tax bracket. Outside of your retirement savings plans, you have several dividend paying stocks and several rental properties.
Since dividends are taxed at the 15% capital gains tax rate and building depreciation offsets your rental property income, you plan on being in the 15% income tax bracket when you retire at age 60.
In such a case, converting to a Roth IRA doesn't make much sense.
After all, at 35%, you end up paying $140,000 in conversion taxes on your $400,000 Traditional IRA.
But if you keep your Traditional IRA, you can withdraw the full amount in retirement at a 15% tax rate and only pay $60,000 in taxes.
That's a difference of $80,000!
So converting to a Roth IRA is not always a good idea. It really depends on your personal financial situation.
If you're a high income earner, expiration of the $100,000 adjustable gross income (AGI) limit due to the new 2010 Roth IRA conversion rules might prompt you to look into the idea of converting to a Roth IRA.
Evaluate your decision based on the same factors outlined above, but also keep in mind that the year 2010 offers an additional benefit for anyone looking to convert, regardless of income.
For the year 2010 only, you have the option of deferring 50% your conversion taxes until 2011 and 50% until 2012. Normally, you would pay the entire tax in the year of the conversion, so this gives you the ability to spread out payment of your tax liability over a span of three years instead of one.
This is yet another factor to consider when figuring out whether or not you should convert.
If you're trying to decide whether or not converting to a Roth IRA is a good idea, you need consider a number of factors. To start, see if you can answer these questions...
How you answer each question goes a long way toward determining whether or not a conversion is in your best interest.
While every circumstance is different, (as a general rule) the older you are, the less sense it makes to convert to a Roth IRA.
Because of the tax hit you take for converting, you'll need some time to generate returns on your Roth IRA investments in order to realize any benefit from the tax-free withdrawals.
After all, if you're converting to a Roth IRA one day, and withdrawing funds the next, the end result is pretty much the same as if you had left those funds in the original taxable account. So take the time to learn the Roth IRA conversion rules and examine your personal financial position before deciding in favor of converting to a Roth IRA.
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