I've been trying out different sets of numbers - time horizon, tax rates, etc. Not surprisingly, the answer to the conversion question is "It depends".
A lot of the decision boils down to: (a) what assumptions are you making on future tax rates; (b) what is the assumed rate of return (i.e. opportunity cost) on the funds that you are using to pay the tax on the Roth IRA conversion; (c) what is the likelihood that the rules for IRA distributions might change by the time you begin to make withdrawals (e.g. last year Congress suspended RMD's for the year).
This last point, I think, is not discussed enough. Congress has shown a remarkable ability over the years to change the tax rules as situations seem to warrant. We already have different tax rates for different types of income, for example; what if Congress decides 10 years from now that IRA distributions are taxed at a lower rate than ordinary income?
In any event, I'm sure there is more discussion to follow.
New Rules Ease Roth Conversions, but Benefits Vary
Don’t be surprised if your broker calls in the next few months and asks if you have thought about converting your traditional individual retirement account to a Roth I.R.A.
That’s because as of Jan. 1, anyone can convert their regular I.R.A. into a Roth regardless of income. Before the rules changed, only people with modified adjusted gross incomes of $100,000 or less could convert their accounts.
So should you consider it?
Anyone who expects to land in a higher tax bracket in retirement should think about converting. With a Roth I.R.A., you pay taxes on your contributions now so you can withdraw money tax-free later. Regular I.R.A.’s, on the other hand, allow you to take a tax deduction on eligible contributions, but you pay taxes when you take out the money.
But the Roth’s benefits extend beyond its possible tax advantages. Unlike traditional I.R.A.’s, you are not required to take required minimum distributions once you turn 70 ½, which makes the Roth an effective way to leave money to heirs — or to save for emergency expenses later in life. And because withdrawals are not counted as income, what you take out won’t affect whether your Social Security benefits are taxed. (Some people with high retirement income must pay taxes on a percentage of their benefits.) So some longtime teachers and doctors with substantial pensions may benefit from converting even a portion of their I.R.A.’s.
There is one exception. If you live in Wisconsin, you will face stiff penalties if you convert your I.R.A.’s. More on that later.
But as with most money-related matters, deciding to convert is not simple. It requires a fair bit of guesswork, namely, trying to foretell your tax bracket in retirement. Many retirees expect to pay less. But with soaring federal deficits and the rising costs of programs like Social Security and Medicare, most everyone agrees that taxes will increase — though by how much and for how long is anyone’s guess.
“It’s not just a function of your own income expectations, it’s also a function of government policy,” said Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research. “There are a lot of intricacies and nuances not only with the tax law itself, but with your unique situation.”
And that’s why many financial planners recommend hedging your bets or keeping your retirement money in accounts that are taxed in different ways — much as you diversify your investments. That way, if the government changes the rules of the Roth itself (or changes the tax code in any number of ways), at least you have your bases covered. “The more uncertainty I may feel about the future, the more likely I might be to go halfway with a strategy and not jump in with both feet,” said Christine Fahlund, senior financial planner for T. Rowe Price.
There are a few caveats. Experts generally do not recommend acting unless you have the money to pay the tax bill for the conversion without dipping into your I.R.A. (If you’re under 59 ½, you’ll also face a 10 percent penalty for tapping your I.R.A.)
You may also be wondering if this is yet another ploy by the investment industry to make more money. The Roth I.R.A.’s do, after all, present an opportunity for the industry to collect and manage more of your assets and charge commissions if you are moving from one investment company to another. But if your I.R.A. is already at a company, like, say, Fidelity or Vanguard and you keep it there, the conversion should not cost you anything.
Though your decision to convert should be based on your circumstances, there are a number of factors that can influence your decision, including these:
Consider If ...
YOU MAY NOT NEED THE MONEY For people who are unsure whether they will need all of their retirement money, it could pay to convert a portion of their I.R.A. for large or unanticipated expenses later in life. After all, Roths do not require account owners to withdraw any money, ever. “Leaving the Roth I.R.A. untapped for as long as possible — as a hedge against longevity or to cover medical or long-term care expenses — can be an appealing strategy for investors, including the huge middle class,” Ms. Fahlund said. “If they never have to tap into the Roth I.R.A., it becomes an attractive legacy.”
YOU HAVE A TAXABLE ESTATE ...Roths are useful tools for people with taxable estates. By paying the tax on the conversion, you are also effectively reducing the amount of taxes you will owe on your estate. Financial planners also recommend that people in the top tax brackets choose to pay the taxes in 2010 to avoid the higher income tax rates scheduled for 2011. Otherwise, the Internal Revenue Service will automatically charge you half the tax in 2011 and half in 2012, when rates are higher.
... OR NONDEDUCTIBLE I.R.A.’S If you earned too much money to contribute to a traditional I.R.A., you may have made contributions with after-tax money. In that situation, the contributions can eventually be withdrawn tax-free and only investment earnings are taxed. Likewise, you would be taxed only on those earnings in a conversion. “It’s a slam-dunk if your I.R.A.’s contain nothing but nondeductible contributions with minimal investment earnings,” said Helen Huntley, a financial adviser in St. Petersburg, Fla.
Nondeductible I.R.A.’s also provide a backdoor entry into the Roth I.R.A. for people who make too much money to contribute directly. Higher earners can make nondeductible contributions to traditional I.R.A.’s and convert them to a Roth I.R.A. each year — and pay little or nothing in taxes because the tax is only on earnings. (In 2010, married taxpayers who earn up to $167,000 can each make the full $5,000 contribution to a Roth, or $6,000 for people over the age of 50. Couples who earn up to $177,000 can make partial contributions. Single taxpayers who earn less than $105,000 can make a full contribution, though it phases out above $120,000.)
YOU ARE YOUNG OR ENGAGED Younger people have an advantage because they have more time for tax-free growth — and to earn back the taxes paid upfront. Another strong candidate for conversion is someone engaged or soon to be engaged whose tax bracket is lower than the combined household’s bracket will be, said Jennifer Lazarus, a financial planner in Durham, N.C. “This person will benefit from locking in lower tax rates, and the converted balance will grow tax-free over the course of their marriage,” she said. “The younger the couple, the greater the tax-free benefit.”
That does not mean that older people should rule out converting. If, for instance, you are required to take sizable minimum distributions from your regular I.R.A., which then push you into a higher tax bracket, it may pay to convert part of your I.R.A., even over a series of years, said Mr. Spiegelman of Schwab. This is especially useful for anyone with sizable pensions.
Think Twice If ...
There are several specific situations where you should not convert. If you expect you will need every penny of your retirement money and you think you will land in a much lower tax bracket than you are in now, it does not pay.
That is also true if you plan to leave your I.R.A. to charity. It will inherit the account and its contents free of tax, said Therese Govern, an accountant and financial planner in Seattle.
Wisconsin residents, meanwhile, should not convert — or at least not yet. The state has not yet adopted the federal tax rules, which means that people with taxable income over $100,000 who convert face stiff penalties. The State Legislature is expected to act by April to eliminate the penalties.
Also keep in mind that if you are under 59 ½, converted Roths must be open at least five years before you can make penalty-free withdrawals. So if you need the money before then and still want to convert, keep enough in your traditional I.R.A. to tide you over. Once you are over 59 ½, there are no withdrawal penalties.
Given the complexity of the tax code, you should work with a tax adviser.
Of course, you should also feel comfortable with your decision. “The process of determining whether or not to convert is not just about economics,” said Terry Donahe, a financial planner in Lake Oswego, Ore. “How does the individual feel about paying taxes now? Given the fragile state of our economy in general and the financial markets in particular, many individuals are reluctant to part with cash.”