Roth IRA Conversions
Congress created Roth IRAs as part of the Taxpayer Relief Act of 1997. Envisioned as a means of encouraging lower-income taxpayers to put away money for retirement, Roth IRAs have become a popular savings vehicle for investors who meet the tax code’s eligibility requirements. At the end of 2007, Roth IRAs held an estimated $178 billion in retirement savings.
There are two ways to set up a Roth IRA, either through regular contributions—much as you might contribute to your company’s 401(k) plan—or through a conversion of assets held in a traditional IRA. Under current law, only traditional IRA assets may be converted to a Roth IRA, although the Pension Protection Act of 2006 made it possible for direct conversions of 401(k) assets into Roth IRAs, beginning in 2008.
Why would someone want to do a Roth IRA conversion? It’s all about taxes. The Roth IRA is funded with after-tax dollars, but withdrawals in retirement are tax-free. Traditional IRAs, by contrast, are typically funded with pre-tax dollars, but account holders must pay ordinary income tax on withdrawals. The conventional wisdom ever since the Roth IRA came into being was that it made sense to do a conversion if you anticipated retiring in a higher tax bracket. The rationale was that it’s better to pay lower taxes on your money now than higher taxes on it later.
Only certain taxpayers can do the conversion. Married taxpayers filing separately are not eligible, and everyone else must meet what the IRS calls a “modified AGI requirement.” Only taxpayers—both those filing singly and married couple filing jointly—whose modified adjusted gross income for the conversion year is $100,000 or less can convert their traditional IRA assets. Beginning in 2010, Americans who earn greater than $100,000 will also qualify for the conversion.
The IRS gives you three ways to accomplish the Roth IRA conversion:
1. Trustee-to-trustee transfer, or rollover.
2. Redesignation as a Roth IRA by the same trustee.
3. Payment of the distribution from the traditional IRA into a Roth IRA within 60 days of distribution from a traditional IRA.
The amount of your Roth IRA conversion is not subject to the 10 percent penalty the IRS imposes on early withdrawals from IRAs, although the conversion amount will be taxed as ordinary income during the conversion year. Note that nondeductible IRAs may also be converted to Roth IRAs. In this case, ordinary income tax is paid on the difference between the account value on the date of conversion and the total amount of the nondeductible contributions. In order to avoid having the IRS impose the early withdrawal penalty, assuming you’re under 59½, you must follow the IRS’s guidelines for doing the conversion.
Now back to that conventional wisdom. If you’re eligible, a Roth IRA conversion is a powerful and flexible way of managing your retirement assets. After your conversion account has been open for at least five years, for instance, you may withdraw your contributions (but not earnings) for any reason without paying taxes or penalties, regardless of your age. Because the IRS has already taken its cut, there are no minimum required distributions from Roth IRAs, so you may pass your account along to your heirs intact, if you wish.
It may very well make sense to do a conversion, but your future tax bracket may be just one part of the analysis. One important factor to consider is the investment opportunity costs of taking money out of a tax-deferred growth account to pay a voluntarily-assumed income tax liability. Another risk is a change in the tax laws that could make Roth IRAs less attractive. A final note: if you have to keep part of the distribution to pay the taxes on your Roth IRA conversion, then it’s probably not worth it. Remember the IRS will impose a 10 percent penalty on early withdrawals from your traditional IRA.
