by Michael Ettinger, Esq.
There have been numerous articles written on the wisdom of converting your IRA, or a portion of it, to a Roth IRA. In 2010, the income limit on converting, previously $100,000 per year, has been eliminated allowing many more taxpayers this option.
Traditional IRA’s offer a tax deduction on the contribution but tax the distribution, required to start after age 70 1/2. Roths offer no deduction on contributions but the distributions are tax-free (after a five year holding period). Unlike a traditional IRA, with a Roth there is no mandatory age to take required minimum distributions.
Should you wish to convert, you will have to pay the taxes on the converted amount now. For 2010 conversions only, you may defer the taxes due as follows: 50% in 2011 (payable April 15, 2012, or until October 15, 2012, if on extension) and 50% in 2012 (payable as late as October 15, 2013). Your tax advisor can help you determine whether you should make quarterly estimated tax payments.
Kiplinger’s says that “It’s worthwhile to make the switch only if you don’t have to tap the IRA for cash to pay the taxes.” Not everyone agrees, as discussed below. But if you convert and don’t have the funds to pay the taxes later, you are allowed to undo the conversion until October 15th of the following year. This is also important if your portfolio has fallen, since you may not want to pay tax on a $100,000 conversion if the value of the IRA has dropped to $75,000.
Many advisors feel that you should Rothify at least some of your IRA in the belief that tax rates today are lower than they will be in the future. Trillion dollar deficits tend to support this thinking.
On the other hand, you might be in a different situation if you are now an income earner and your tax bracket will fall when you retire.
Clients like the Roth for its flexibility. With no required minimum distribution, you do not have to pay taxes on money you may not need, but are required to take with a traditional IRA.
By setting up multiple Roth IRA’s, or by converting in a series of steps, say $50,000 now and $50,000 in four months, you will be in a better position to undo some of your conversions should your portfolio fall or you are unable for any reason to pay all of the tax due.
For New Yorkers, if you are moving in the foreseeable future to a state with no income tax, such as Florida, you may want to wait until you move to convert. If you are collecting Social Security you may want to ask your tax advisor whether the conversion will cause more of it to become taxable. Remember, taxes on Social Security, as well as your Medicare premium rates, are calculated on your income. If you are older than 70 1/2, you must take your required minimum distribution before converting, which may also affect your tax bracket.
Whereas Kiplinger’s says don’t convert if you have to pay the taxes from your IRA, the Wall Street Journal disagrees. They found, after running the numbers, that it may pay to convert even if you have to pay the taxes with money inside the IRA. The reasoning is that even though the Roth will be smaller after the taxes are paid, by not having to take withdrawals, some clients will be able to keep more of their Social Security tax-free. By keeping more of their Social Security, they will have to take less from their Roth, allowing it to grow more. In one example using this strategy, the odds against a couple outliving their savings fell from 50% to 12%.
As you can see, converting to a Roth is a mind bending calculation that requires the input of your financial advisor, your accountant and your own wisdom of Solomon.