Roth IRAs have been around awhile, but income restrictions have limited higher income taxpayers' ability to either contribute to a Roth or to convert traditional IRAs into them. For 2010, that income restriction is eliminated for conversions, but the window of opportunity is closing. For this year only (unless Congress extends beyond 2010), ALL taxpayers can convert their traditional IRA (including SEP IRA or SIMPLE IRA) in part or in the entirety, which generally accelerates taxable income in the year of conversion. However, for 2010 conversions only, taxpayers can elect to spread the taxable income triggered by conversion evenly over years 2011 and 2012, thereby spreading and deferring the taxable income. Whether or not this makes sense depends on individual factors specific to each taxpayer as well as a host of assumptions.
Let's try to break down what should be considered in this decision.
Why a Roth?
Unlike traditional IRAs, qualifying withdrawals from Roth IRAs are income tax free and are not subject to minimum distributions (RMDs) at age 70 1/2 . Qualifying distributions are those taken after account owner (1) had a Roth account opened for at least 5 years and (2) reached age 59 1/2. Clearly an IRA account that doesn't have to pay tax on its growth is going to deliver larger after-tax (net) withdrawals than IRA withdrawals that must pay tax. But does it makes sense to intentionally accelerate tax on (convert) an existing traditional IRA in order to obtain a Roth for retirement and beyond?
Assumptions on Conversion
Everyone that converts a traditional IRA to a Roth IRA is making a bet that the amount of accelerated tax will be more than overcome by overall growth and potential tax savings over time from the Roth. Specifically, the main assumptions every taxpayer considering conversion must address:
1. What is the effective income tax rate on the conversion vs. the effected tax rate the taxpayer anticipates he will be subject to in the future upon eventual withdrawal? Conversion makes more sense if effective rates at time of conversion are less than in the future.
2. What is rate of growth or return on the IRA? What is the time horizon before I would start withdrawal? The longer the time horizon and higher the rate of return would both favor conversion.
3. Can I pay conversion tax from funds outside the IRA? Using funds outside the IRA to pay the tax can be constraining on the outset but allows more funds to be retained within the Roth IRA for future tax-free growth.
The following chart can be used as general guidance to illustrate the aforementioned assumptions in play but should not be adhered to under absolute terms:
How to Hedge your Bet
As I mentioned, taxpayers who convert their traditional IRAs are making a bet. For some, the decision is simple but for most it won't be so clear-cut. Here are some additional "wildcards" that may shift the betting odds in your favor:
1. Partial conversions are allowed. Converting is not all or nothing and taxpayers have the option to convert some IRAs or a proportion of one more IRAs. This can allow taxpayers to straddle the decision a bit and also avoid a large spike in taxable income and marginal income tax rates in the year of conversion (keep in mind an election for 2010 to spread income into 2011/2012 is available).
2. Time the conversion when account values are depressed. Conversion is not selling the IRA, so identifying a low point in value to time the conversion is not surrendering a loss. Quite simply, the lower the account value on the conversion date, the smaller the tax bill. Of course, you only have until 12/31/2010 to decide if the market will provide a lower valuation conversion opportunity the remainder of 2010.
3. Ill-fated conversions can be reversed! Everybody loves a do-over or mulligans as the golfers love to say. A taxpayer has up to October 15 (extended due date) of the year following conversion to change his or her mind after the fact. This is called a recharacterization which effectively reverses the conversion back to the traditional IRA . This wipes the conversion away like it never occurred, and effectively provides a form of hindsight on your decision well into the next year.
4. Split converted accounts into separate Roth IRAs. Considering investing different forms of investments (ie fixed income, real estate, small-cap equities) into separate Roth IRAs. That way, if say the real estate fund in a separate Roth IRA is "tanking" but other investments are doing well, the recharacterization can be limited just to the real estate fund investment (a separated nonperforming Roth IRA account) instead of the entire Roth IRA in aggregate.
You Gotta Have Faith
Ultimately, no matter how well thought out your conversion consideration is, there's a leap of faith involved. For example, it's hard to imagine where income tax rates will be in twenty years, especially when it's unclear where they'll even be in 2011. And we're coming off a lost decade of investment performance in the stock market, so using historical returns to predict future performance might even seem more perilous. It's also worth noting that social security benefits were never intended to be subject to income tax until Congress decided about twenty-five years ago it was too large an income source to leave alone (currently 85% of social security benefits can be subject to income tax). Could the same renege occur to Roth IRA accounts?
Still a bit unclear? It will be to many, because a good decision here is predicated on future events that are uncertain. But for some, it is a clear opportunity to jump over to a Roth with little downside. For the rest of you, did you really didn't expect me to make your decision for ya?
