In-Depth Articles
Should You Convert Your Traditional IRA to a ROTH IRA?
If you are thinking about converting your Traditional IRA to a ROTH IRA, there are several key factors you should consider. While conversion is a good idea for many, it may not be one size fits all. Let’s take a look at some of these factors.
When you convert a Traditional IRA to a ROTH IRA you have to include the amount converted as Gross Income in the year of conversion. This will generate additional tax calculated at your marginal tax rate. If you plan to use a portion of the converted funds to pay the tax then you are decreasing the amount going to the ROTH IRA. This will diminish the benefit of the tax free growth within the ROTH IRA considering the principal may now be lower by the 28% or more used to pay the tax on conversion. Additionally, if you do retain some portion of the converted funds for taxes and you are under 59 ½, you will incur a penalty on that portion. If, however, you convert all of your funds into the ROTH IRA and pay the taxes from other sources then you maximize the amount available to drive the tax-free growth. One side note here is that if you have cost basis in your Traditional IRA, perhaps from previously making non-deductible contributions, then the amount of converted funds subject to tax is the amount in excess of your basis.
Tax rates should also be considered. If you believe that your tax rate now is considerably higher than what it will be when you begin to withdraw from your Traditional IRA then it may make tax sense to refrain from converting. Often, after retirement, your income will decrease considerably resulting in a much lower tax bracket.
The time factor is also important in making your decision. If you convert now and pay 28% or more in taxes then you need to have enough time for the tax free growth within the ROTH IRA to surpass the current tax paid in order to realize the benefit of converting. If you think you may need to withdraw the funds in the future, then make sure that need is far enough away to have made your conversion worthwhile.
Tax advantages exist if you will not or may not need the funds for retirement. Unlike Traditional IRAs you are not currently required to take minimum distributions from your ROTH IRA at age 70 1/2. This allows the funds to continue to grow tax-free until you actually need them or until your heirs are required to withdraw the funds.
The current and upcoming rules may also play a part in deciding to convert. Currently you can only convert to a ROTH IRA if your Modified adjusted Gross Income (MAGI) is $100,000 or less. Recent tax laws also state that if you wait to convert until 2010 that income limitation goes away. This new legislation allows you to elect to defer the inclusion of income to be reportable equally in 2011 and 2012 rather than 2010.
As you can see, there are several factors to consider when making the decision to convert your Traditional IRA to a ROTH IRA. We at Hughes, Snell & Co., P.A. are knowledgeable of these rules and have the tools available to help walk you through this decision making process. Please contact us if you would like to discuss your specific situation.
To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used for the purpose of avoiding penalties assessed under the Internal Revenue Code.
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