The Roth IRA conversion: yes or no?
- February 12, 2010
- 14 comments
- Posted in Investing, Latest Posts, Retirement
Roth Individual Retirement Accounts are big news this year. For the first time, anyone with a traditional IRA can convert it into a Roth. You can spread the tax effects of a 2010 conversion over two years. And conversion sidesteps the usual 10 percent penalty on funds withdrawn from traditional IRAs prior to age 59 ½. Should you convert? In some cases, the answer is “yes,” but many of you should keep the traditional IRA you already have. This post can help you decide. But first, some background:
Roths offer three big advantages: (1) The earnings that accumulate can be withdrawn tax free, as long as you meet the age and holding-period requirements. (2) You’re never required to make withdrawals if you don’t need the money. (3) You can leave the Roth to your heirs income-tax free. With traditional IRAs, by contrast, withdrawals are taxed, you have to start taking them at age 70 ½, and income taxes are due on IRA money left to heirs.
But there are costs to the conversion. You owe income tax on any money withdrawn from a traditional IRA and switched into a Roth. How will you pay it? If you pay with money taken from your traditional IRA, you’ll be putting much less into your Roth. Conversion works best if you pay the taxes out of other savings, so that your entire IRA investment can be turned into a tax-free Roth.
So there are the facts. What should you do? I asked IRA guru Ed Slott, certified public accountant and author of “Stay Rich for Life” and other books about getting the most out of your IRA. Here are his guidelines:
–Convert if you’re wealthy and won’t need the money in your traditional IRA. The taxes you pay now amount to a gift to your heirs so that they can inherit income-tax free.
–Convert if you’re working, are several years away from retirement, and have enough savings on the side to pay the taxes due on the switch. If you don’t have enough savings to pay the conversion taxes all at once, convert smaller amounts of money each year. That way, you can probably pay the taxes out of your regular earnings. This kind of conversion resembles pre-paying your mortgage. Once it’s over, your retirement income is bought and paid for, free and clear.
–Convert if you’re young and are in a low bracket. Even if you have to pay the tax out of your IRA assets, it will probably be small. You have many, many years to make additional contributions that will grow income-tax free.
–Convert even on your deathbed, if you’re rich enough to owe estate taxes. You’ll save more in estate taxes than you’ll pay in income taxes.
–Don’t convert if you’re older, living on your savings, and will need all the IRA money you have to pay your future bills. It makes no sense to reduce modest assets by paying taxes in advance.
–Don’t convert if you’re close to retirement and will need all your IRA savings to pay future bills. You can’t afford to take a tax hit now.
–Don’t borrow to pay the taxes due on the conversion. That puts you further into debt and adds interest payments to your monthly bills. Instead, convert small amounts of your traditional IRA every year and pay the taxes out of earnings.
For a quick look at whether you should pursue a conversion, use the calculator at http://www.72t.net/RothIraConversions. If it’s a go financially, and you’ve passed the tests listed above, call up the firm where you keep your IRA and tell it to change the account. Presto, you now have a Roth—no fuss, no muss. If you want to convert only part of your IRA savings, the firm will roll that portion into a separate Roth IRA account.
Tags: Individual Retirement Account, IRA, Roth conversions, Roth IRA
Hi Jane,
I enjoyed your interviews on KCTS Seattle public radio yesterday and the week before. Here are some questions for you re. Roth conversions:
–Convert if you’re working, are several years away from retirement – HOW MANY YEARS FROM RETIREMENT?
I am 62 and can not retire until 70. Depending on the tax bite I could pay taxes from saving.
Thanks – Mike Noblet
If you don’t expect to be drawing from your IRA when you retire, you could convert now. Or consider converting just part of the money (the part of the account that you think you won’t need).
Jane,
Some feed back on your recent AARP article “Financial Freedom, 12 easy steps”.
I must question your advise on #7..”Be smart about SS”.
I am age 60. My SS payment at 62 would now be about $1700. And at 70 would be about $3100. Taking the $1700/mth X 12(mths) X 8(yrs)= $163,000.00
If I wait until I am 70 to begin my payout at $3100, I lose forever that $163K. I would do exactly the reverse of what you suggest. Take my $1700 at age 62 and DEFER as long as possible my non-taxable Roth IRA and also my taxable 401K and my taxable traditional IRA withdrawals and let them grow (hopefully!) for as long as I can.
I am not married. I have a good pension plan. Comments please? Thanks, Scott Heyworth
One reason could be taxes. If you use up the taxable income from a traditional IRA in your early retirement years, you’re less apt to own taxes on your Social Security income, when you finally claim the benefitw.
The larger reason is longevity. The odds are high that you will live longer than you think. In your plan, you’re staking your later years on the success of your investments, which might or might not work out. Social Security is inflation proof and guaranteed. I think of it as longevity insurance. You give up current benefits to take much larger benefits in the future, in case you exceed the average lifespan. For a more detailed discussion of this point, see http://www.esplanner.com/case-when-should-i-take-social-security.
regarding change to Roth IRA from standard IRA; I am 70, with IRA worth approx 800K. from what I can determine thru turbo tax, i would have to pay approx $262k in fed tax and $3800 in state tax. thinking ahead to leaving to
my estate, (children), is this a good idea? I think i have enough to live on with out that IRA money, but who knows. Paying 270k taxes does not appeal to me at all!
If you switch to the Roth, you are choosing to pay the taxes that your children would otherwise owe on their IRA inheritance. I don’t see it, in your case. It’s possible that you might need the money. Besides, your children can put off paying the tax right away by setting up what’s called an “inherited IRA.” The money would go from your IRA to theirs, and they could make withdrawals (and pay the taxes) over their lifetimes, if they chose–letting most of the money continue to build tax deferred. Make sure they know about inherited IRAs (the IRAs have to be titled correctly), and then forget the Roth conversion. It makes more sense for younger people with a smaller tax to pay.
Jane, your statement in paragraph 3 regarding “any money” withdrawn/distributed from a TIRA (and then converted into a Roth) being taxed may need revision. What about non-deductible contributions? I believe a non-deductible situation gets into basis held in the TIRA and reduces the portion of the distribution that is taxable. Thanks.
You’re right. Non-deductible contributions to a traditional IRA make Roth conversion more complicated, tax-wise. But the principle is the same. Pay the taxes from other sources, not from the money that can be transferred in the Roth tax-free.
Jane,
I could afford to convert my Roth IRA in 2010 if I use the money I was planning to contribute to a Roth IRA in 2011 and 2012 to pay the taxes on my 2010 conversion. Would this make sense? Or would I be better off keeping my traditional IRA intact, and making my planned Roth contributions in 2011 and 2012? I am in my mid-30s, already have a decent nest egg, and expect to be in a similar tax bracket in retirement.
Thanks for your excellent blog and books — I recommend them to everybody who asks me where I go for financial advice.
Thanks,
John
Thanks for the compliment, John. Your very specific question depends on tax and investment projections for someone in your bracket, taking your asset allocation into consideration. I can’t do that — but an accountant or financial planner can. Generally speaking, younger investors should convert but perhaps not at the cost of two years of additional contributions. Still, this is a pure financial calculation, very specific to your situation.
My mom has a tradtional IRA worth $150,000. She is 63 yrs old and retired. She does not currently need the money in her IRA for living expenses. She is in a low tax bracket. Does it make sense for her to convert to a Roth IRA? Thank you
It’s all in the numbers. How long will it take her to make up the taxes that she paid on the conversion? For people in low tax brackets, Roths are less interesting. They’re also less interesting if the taxes have to be paid out of IRA proceeds rather than from other sources. If she thinks she will never need the money, however, she might convert as a favor to her heirs (she’s be paying the taxes in advance, so that her heirs wouldnt have to)
My wife and I converted $151,000 from our traditional IRA’s to our individual Roth IRA’s in the State of Massachustts. On December 17 we sold and passed ownership of our home in the state os MA.Should we recharacterize to avoid MA state taxes as we moved permanently to Florida in January 2011, a State tax free State and recently set up Homestead exemtion in Florida?
Thanks for asking but this is a question for your accountant. It will be purely an individual numbers game