Insights & Advice


Should You Convert your Traditional to a Roth IRA?

Next year investors will be given a once-in-a-life-time chance to convert their traditional individual retirement accounts into Roth IRAs regardless of how much you earn. Most savers’ knee-jerk reaction is to convert, pay the taxman now and forevermore be free of giving the government a cut of their tax-deferred retirement money. When I dig beneath the surface of this transaction, however, I’ve discovered a few things you should consider.

Under the current 1977 tax law for Roth IRA conversions, individuals are permitted to convert a traditional to a Roth IRA but only if your adjusted gross income(whether married or single) is no more than $100,000. In May, 2006, President Bush changed the rules for one year only. Starting in 2010 taxpayers earning more than $100,000 will be allowed to convert and the taxes due on the conversion can be spread out over two years. So a 2010 conversion amount can be included as taxable income in 2011 and 2012 lessening the impact of the tax bite.

Now removing the cap for one year doesn’t mean that any one can open a Roth IRA. Taxpayers are still restricted based on the amount of income they earn. For example, married couples, filing jointly earning between $166,000-$176,000 and singles earning between $105,000-$120,000 are phased out of contributing beginning at the lower number.

Obviously, the draw in converting your IRAs is based on how they are taxed. Traditional IRAs are tax –deferred meaning the money you contribute each year is not taxed until you start withdrawing it when you retire when hopefully your tax bracket is much lower. In a Roth IRA, the money you contribute is after-tax income but tax-free when you withdraw it (there is a minimum holding period of five years).

There are two concerns in converting that I can identify. Taxes as I’ve mentioned before are already at historically low rates as are marginal tax rates. How do you figure your marginal rate? That’s easy. Let’s say the money you earn this year puts you at the very top of the 25% tax bracket. Then you make $200 more in a bonus, that money will be taxed at the next higher tax rate (the marginal rate) which is 28%. That’s the rate at which the IRA conversion will take place in 2010.

But if you keep your money in your traditional IRA when you retire and start to withdraw you will be only taxed at your tax bracket not at the higher marginal rate. Depending on how much you have in your traditional IRA that could be a substantial tax savings.
Your accountant will also tell you the cardinal rule of tax management which is to defer, defer, defer. Don’t give the government one penny before you have to. By paying in 2010, you forego the ability to grow that money tax-free in your traditional IRA for how ever many years before your retirement.

My second concern is the government itself. I don’t trust the politicians. Just because the lawmakers promise you something today doesn’t mean they won’t take it back tomorrow. In 1986 when a third of American had an IRA and 75% of them were middle class taxpayers, Congress arbitrarily imposed severe restrictions on the deductibility of contributions. Even now our 401(K) plans are being “reexamined” by the Hill and there is the possibility that some higher income earners may have their tax exemptions restricted.

Then there are tax changes. For example, marginal tax rates have been all over the place over the last century ranging from 7% for those making above $500,000 in 1913 to 94% for those making above $200,000 in 1944 to 35% currently on income above $385,000. Tax brackets have been stretched like rubber bands as well.

So will taxes be higher or lower when you retire? That naturally depends on how old you are now and how long before your retirement. It is a real crapshoot but given the deficit, the Social Security and Medicare issues, does anyone seriously believe that tax brackets and marginal rates in the near future won’t be higher?

If you are wealthy( I mean $4 million or more wealthy) making half a mill a year or if you are just starting out and expect to earn big bucks in the future then converting is a definite winner. In a Roth, unlike a traditional IRA, there is no minimum required distribution starting at 70 ½ years of age. That means you could conceivably leave all that tax-free money to your heirs.

For the rest of us, whether to convert or not is a question that should be studied, possibly to ask your tax accountant or financial planner. Which ever way you go you have almost a year to decide.

Posted in A Few Dollars More, Financial Planning, Retirement