Insights & Advice


Stay with a Traditional or Convert to a Roth in 2010?

This year the tax laws are changing. If you have a Traditional IRA, Roll-Over IRA or another tax deferred plan like a 401 (K), 403 (b) or 457 (b) you can now convert to a Roth IRA, regardless of income level. Better yet, the government is giving you an added incentive to convert by allowing you to pay the taxes due on the conversion over two years. So why are so many investors hesitant to do it?

If this topic sounds familiar, it is, because back in March, 2009 I wrote a column on this opportunity to convert. Unfortunately, at that time it appeared the financial world as we knew it was coming to an end. The stock markets were at their lows, the popular media had us believing we were entering the second Great Depression and converting to a Roth IRA was not high on anyone’s agenda since everyone’s savings were going to be wiped out anyway.

From the avalanche of requests I’ve been getting from clients and readers alike, I thought it advisable to review the pros and cons of conversion now that most people believe we are back on the road to recovery. First, a few basics in the mechanics of both Traditional and Roth IRAs: contributions to a Traditional IRA are tax-deferred, until 70 1/2 years of age. At that time, you are required to take a minimum distribution (RMD) each year at whatever tax rate you are in at the time. If you pull money out of a traditional IRA before 59 ½ years of age, there is a 10% penalty with some exceptions (hardship, a down payment on a home, education, etc.).

In comparison, a Roth contribution is after-tax money that will grow tax free forever. There is no RMD, there are no withdrawal penalties after five years and you can keep contributing until you stop filing a W-2. Up until 2010 there was a salary cap of $100,000 or under to qualify for converting. That cap is gone for this year. For the first time, over 13 million investors will be eligible to convert to a Roth IRA if they want to. Who should convert?

Anyone who isn’t working or who is retired and living on a fixed income generally make good candidates for conversion. The caveat, of course, is that you need to have the extra money available to pay the taxes on the conversion, even if you have until 2012 to pay them. And no, you don’t want to pay the taxes by taking even more money out of your IRA. That would defeat the purpose of the entire exercise. For retirees, there is an added catch. If you are taking social security, the added income you have to report from the conversion may cause more of your social security benefits to be taxed that year.

Future tax rates should also be a consideration for all of us. In my prior column, I pointed out that with the historically high deficits we face; does anyone seriously believe they won’t be paying higher taxes in the future? Income taxes, for example, are scheduled to increase in 2011. The current tax brackets of 25%, 28%, 33% and 35% will revert to their pre-2001 levels, which will mean that regardless of bracket, we will all be paying 3% more in taxes. That’s just for starters. Conceivably, you could be paying higher taxes in retirement than you are paying now as a wage earner if government has their way.

Bottom line: If you expect your income to increase in retirement or if you expect (or want to hedge against) higher future tax rates and if you have enough assets outside your Traditional IRA to pay the additional taxes, then you might want to consider conversion.

If, on the other hand, you are well-off and plan to leave assets to your children then the Roth IRA can be an ideal wealth transfer tool. Since there is no RMD, your Roth can continue to grow and earn unobstructed by mandatory withdrawals. It can be passed on to your beneficiaries who will enjoy the tax-free benefits of the inherited Roth, especially if they reframe from tapping it until they retire.

If you are leaving it to your grandchildren, the benefits could be even greater. Inherited IRAs can be distributed over the beneficiary’s life expectancy. Given the long life expectancy of say, a three year old grandchild, required distributions should be relatively small allowing the bulk of the Roth assets to grow for many decades.

For those above $3.5 million in assets, a Roth conversion is a no brainer in my opinion. Prepaying the tax on a Roth conversion, you can reduce your estate by the amount of the tax. That would reduce your estate tax at the time of death. Given estate tax rates as high as 45%, the potential estate tax savings trumps just about any other consideration.

As you can see, there are a number of variables in this equation that are based on the future—tax rates, your income, the tax code in general—which we can’t possibly know. So converting for one person might make good sense, while for another, it could be a disaster. Your tax accountant should be your first stop in working through some of these areas I’ve mentioned. Once you know the facts as they pertain to you, you can make an educated guess as to your possible outcomes. That’s about all you can expect.

Posted in Financial Planning, The Retired Advisor