2010 Roth Conversion: Factors to Consider Before Making a Decision

The following is a guest post by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting for Charles Schwab & Co., Inc.

For more than a decade, Roth IRAs have been offering investors a number of benefits generally including tax free growth in earnings, tax free withdrawals assuming you begin your withdrawals after the age of 59 1/2 and have held the Roth account for the minimum five-year holding period, and no required minimum distributions as is the case with traditional IRAs.

Through the end of 2009, conversion to a Roth IRA from other retirement accounts including a traditional IRA or 401(k) plan is limited to people with a modified adjusted gross income of $100,000 or less. But as of January 1, 2010, all investors will be eligible to convert funds from a traditional IRA or 401(k) to a Roth IRA, regardless of income level. While this change will present some attractive options for certain investors, people should weigh the costs and the benefits unique to their own specific financial plans and tax situation before deciding if a Roth IRA conversion is right for them.

What is Roth IRA? How is it different from a traditional IRA?

Roth IRAs offer several unique characteristics that differ from a traditional IRA. First, growth in a Roth IRA is generally income-tax-free, meaning that while you pay taxes on your initial contributions, you do not pay income tax or capital gains on any earnings in your Roth account, assuming you begin your withdrawals after the age of 59 1/2 and have held the Roth account for the minimum five-year holding period.

Second, qualified withdrawals after the age of 59 1/2 are tax-free, which can be very useful for people seeking to manage their income tax bracket in retirement. In addition, unlike a traditional IRA, in which required minimum distributions (RMDs) are mandatory beginning age 70 1/2, a Roth IRA does not require withdrawals at any time during a person’s lifetime, so investments can remain in the account and continue to grow until they are needed.

Third, contributions can be withdrawn from a Roth IRA at any time tax-free, but they are not tax-deductable up front. Conversely, contributions made to a traditional IRA may be eligible for a tax deduction when contributed and are taxed upon withdrawal, but cannot be withdrawn without penalties until the age of 59 1/2.

The case for converting: What are the potential benefits?

While the two main reasons that investors typically consider converting to a Roth IRA are to achieve a greater ending portfolio value or to capture estate planning benefits, there are a few additional potential benefits as well. Here a few reasons converting to a Roth IRA might make sense:

• Potentially greater ending portfolio value: If you think your future tax rate will be the same or higher than the rate you're currently paying, you may enjoy a greater ending portfolio value if you convert your funds to a Roth IRA now, because the taxes you pay on the conversion amount today will likely be less than the taxes you'd pay on withdrawals from a traditional IRA in the future.
• Estate planning: If you don’t think you will need to utilize your IRA to live off of in retirement (including emergency expenses such as health care) and your goals include maximizing the assets you leave to heirs and beneficiaries, a Roth IRA can offer some unique estate planning benefits. While the value of a Roth IRA will still be included in a person’s gross estate, because there are no required minimum distributions, the account could grow larger than it otherwise might under traditional IRA distribution rules. This can leave more for heirs to withdraw income tax-free over their lifetimes. In addition, the income tax paid at conversion (preferably from assets other than the IRA) will reduce the owner’s gross estate. In effect, the account owner is prepaying income tax on behalf of future beneficiaries without such payment being recognized as a taxable gift.
• Tax-risk diversification: Risk diversification is a key tenant of investing and diversifying tax risk can be an important factor to consider. Diversifying income tax risk means considering whether and how assets should be divided among three primary types of accounts:

• Taxable accounts in which taxes on investment income and capital gains are paid as they occur,
• A tax-deferred account such as a traditional IRA in which taxes are paid at the ordinary rate in the future when you make withdrawals,
• And a tax-free Roth IRA account in which contributions are after-tax and/or taxes are paid upon conversion for investments going into the account, and qualified withdrawals are income tax-free.

• Flexibility to influence income tax bracket in retirement: Individuals in a higher tax bracket at age 70 1/2 might be forced to take RMDs from a traditional IRA even though they do not need the money at that time. This can also result in taxation in a higher tax bracket. Converting some assets to a Roth IRA will lower RMDs from a traditional IRA, thereby lowering taxable income and potentially even an individual’s tax rate. Roth IRAs allow for additional flexibility in retirement since Roth IRA qualified withdrawals are tax-free and there are no required minimum distributions from a Roth IRA.

Roth IRA conversion considerations to keep in mind: Know the consequences!

The act of converting a traditional IRA or 401(k) to a Roth IRA might have consequences that make it less attractive or appropriate for certain people. The most significant of which is the tax that becomes due at the time assets are withdrawn from a traditional IRA, but there are some other things to keep in mind as well.

• Income taxes due: Converting traditional IRA assets to a Roth IRA triggers a taxable event. It does not make sense to convert to a Roth IRA if you cannot afford to pay these taxes from a readily available source other than the IRA. Investors who are younger than age 59 1/2 will incur a 10% early withdrawal penalty if they use funds from their traditional IRA to pay the conversion taxes. Investors over the age of 59 1/2 could pay taxes from their traditional IRA with no additional penalty, but this would significantly diminish the potential tax-free growth benefits of a Roth conversion versus paying the tax from sources other than the IRA.
• Five-year lock up on conversions: Funds converted into a Roth IRA are subject to a five-year rule, which will result in a penalty if broken before age 59 1/2. There is a five-year waiting period for withdrawals for each conversion amount, which starts on the first day of the year in which the conversion is made. This rule only applies to the specific assets that were converted, not to withdrawals of earnings, contributions or previous balances.

The bottom line is that converting to a Roth IRA can be a complicated, individual decision with tax implications, so you should be sure to consult a professional tax advisor before making any final decisions. Additional details about the 2010 Roth IRA conversion rule changes and Roth IRAs in general are available at www.Schwab.com/Roth.

This information is for general informational purposes only and is not intended as an individualized recommendation or to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

Comments

[Rick Francis]

Another benefit of the Roth conversion is that it is equivalent to sheltering an extra $X, where $X is the tax you pay for the conversion.

Here is an example:
Start with $1000 in tax account $4000 in a standard IRA. Assume invest both for 5 years getting 8%/year.
$1000 becomes $1,469.33 before taxes and $1399 (only gains are taxed at long term rate of 15%)
$4000 becomes $ 5,877.31 before taxes and $4408 (entire amount is taxed)
After Tax Value: $5807

Use $1000 to pay conversion taxes to put $4000 into a Roth IRA, again invest for 5 years getting 8%/year.
$4000-> $ 5,877.31 no taxes are due.

The Roth solution is worth $70.31 more, which is EXACTLY the amount of tax paid on $1000 invested outside of a retirement account.

-Rick Francis

[MC]

Yikes, I still find this confusing. I have a traditional IRA that I paid into for a few years beginning over 20 yrs ago. Its value has increased 8-fold from what I originally put in. My financial adviser said I'd lose almost 50% of it to taxes if I converted it into a Roth, so I'm just leaving it alone for now--any better advice? I'm 48 and not currently in a low tax bracket nor do I expect to be after I retire.

[FMF]

MC --

I agree -- what to do isn't clear. The good news is that we have a year to figure it out. I'll be writing more about it in 2010 as I try to figure out myself what action to take.

[Leigh Ann]

If my traditional IRA is funded with money I've already paid taxes on (no deduction claimed), then I won't have any taxes due upon conversion. Is this correct? Or, would I pay taxes on the earnings?
Also, will I be able to continue to contribute to the Roth IRA in future years, or is this a one-time conversion?
Thank you!

[brooklyn money]

I am happy to have this opportunity for the first time, but do not look forward to paying taxes on converting. I'm looking to convert about $20K. Is this just added to my taxable income for 2010? I'm trying to reduce my taxable income not increase it.

[A Girl and A Boy who love each other.]

Rick Francis, wouldn't your math be incorrect if you are in a 15% tax bracket now, but plan to be in a high tax bracket in the future...

If you are in the same exact tax bracket, it seems it just doesn't matter.

[Josh Stein]

You'd pay taxes on the earnings, but the principal would convert tax-free.

You may contribute to the Roth in future years, and I believe you'll be allowed further Roth conversions (subject to limits on both the amount and your income) even.