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Plan Well, Retire Well

Saving and investing your money

Converting to a Roth IRA, Part 2: Factors to Consider


What is it that determines whether converting to a Roth is a financially good decision? That's the $64,000 question, and in this case, that amount could literally be the value of the question. Roth conversion calculators abound on the internet, but before you use them, it might help if you understand the significance of the information you'll be asked to provide. And, there are some factors the calculators probably won't take into consideration.

I hope you'll find this information clear and easy to grasp. I appreciate the comment sent by Brenda from Virginia about Part 1 of this series: "Impressive and full of information. It will take a second read to digest all of it, but I plan on coming back!"

Factor

How it affects a Roth conversion

Favors:

Do online calculators consider this?

Non-deductible contributions make up a significant proportion of the balances in your non-Roth IRA accounts.

You will owe no tax on that proportion of the converted amount.

Conversion

Yes

You are under age 59, and you will have to use money from your IRA to pay the tax on the conversion.

You'll be hit with a 10% penalty on that amount, in addition to regular income tax unless you qualify for an exception.

Traditional IRA

Maybe. Most calculators assume you are paying the tax from other funds; check the assumptions, which should be spelled out.

Your estate is large enough that you expect to owe estate tax.

Taxes you pay now will be removed from your estate, reducing the amount of estate tax owed.

Conversion

Probably not.

The beneficiary who will inherit the IRA upon your death is in a much lower tax bracket than you.

If you convert, you'll pay more taxes than your heir would.

Traditional IRA

Only if it's a very comprehensive one.

You don't need the money in your IRAs to live on, and you'd rather leave it all to your heirs.

A Roth IRA does not require annual distributions at age 70 for the account owner.

Conversion

No

You can pay the tax on the conversion without using any of the money from the IRAs you are converting.

You'll owe tax but no penalties, and gain tax-free earnings on a greater amount of money than in your Traditional IRA. It's as if you contributed additional money to your IRAs.

Conversion

Yes.

Your income this year (or in 2011 and 2012) is much lower than it will be in future years. Perhaps you've retired but are not yet collecting Social Security or taking distributions from retirement accounts. Or you only worked part of this year.

The tax rate on the conversion may be lower than the rate you'll owe if you wait.

Conversion

Calculators will indicate whether converting makes sense, but they're unlikely to help you decide which year is the best one in which to convert.

You plan to leave your IRAs to a charitable organization.

Charities pay no income tax, and your estate won't pay estate tax on amounts left to charitable organizations.

Traditional IRA. However, you will have to take minimum distributions beginning at age 70. The longer you live, the smaller this advantage will be.

No. I'm not aware of any calculators that consider estate tax. A few may consider the income tax rate of the beneficiary.

Your heir has a high income and is in a higher tax bracket than you.

This doesn't impact your personal finances, but it does affect family wealth: a traditional IRA leaves the income tax burden to the heirs.

Conversion

Maybe. Some more sophisticated calculators ask about the age and income of the heir.

You are receiving Social Security benefits and have Medicare.

The additional income from a conversion may cause you to pay tax on 50 to 85% of your Social Security benefits, and it could increase your Medicare premiums significantly.

Traditional IRA.

Probably not.

You will be applying for financial aid for college for yourself, your spouse, or a child next year.

Income from a conversion could reduce the amount of financial aid. Balances in retirement accounts are not considered in the federal financial aid formula.

Traditional

No.

You have a family member in college, and your income is within the limits for tax breaks such as the American Opportunity Learning Credit or the tuition and fees deduction.

The additional income from the conversion may cause you to lose these tax breaks.

Traditional

No.

As you can see, this decision can be very complex. You may want or need professional advice. Check our Choosing a Financial Professional website for tips on choosing a financial planner or tax expert.

Still to come: My next post will present some scenarios and demonstrate how changing one factor, such as your future income tax rate, can impact whether converting or sticking with your Traditional IRA will come out ahead.



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Who needs estate planning? In a word: EVERYONE. Whether you are a parent, a property owner, or a professional, you need to protect your family and assets. We recognize that the decisions we make together as they pertain to the handling of your estate will affect you and your family during your lifetime and for generations to come. www.wfplaw.com
by Michael Wild on Tuesday 8/30/2011

I work and make over th limits for a IRA. Have 401k at work and max it out. Want to open a IRA this year and then convert it to a roth. My wife is a stay at home mom. Can I open a combined IRA and put $5000 for me and $5000 for my wife so we have $10K in a IRA ? then want to convert it to a Roth IRA. Main goal is to get $10K into a Roth. Can I do this again in 2011 http://fidelityrothira.net
by roth ira on Tuesday 9/13/2011

Congratulations on maxing out your contributions to your employer plan and zeroing in on an IRA as your next target. Yes, you can contribute up to $5000 for yourself and up to $5000 for your spouse as long as your earned income totals at least that amount - but the deposits must be made to separate accounts, one in your name and one in your spouse's name. And yes, you can convert money from a traditional IRA into a Roth. Some financial experts I know are advising clients to wait until the next year to convert, so that the IRS doesn't challenge this quick contribution/conversion as a de facto Roth contribution for someone whose income makes them ineligible for a direct Roth contribution. Check my posts from February 2010 for more about conversions.
by Karen Chan on Tuesday 9/13/2011