Is a Roth IRA Conversion Right for You?

Individual Retirement Accounts (IRAs) are part of a financially secure retirement for many people. Regular IRAs became popular in the 1980s and the Roth IRA was created in the late 1990s. For many, balances in their IRAs have become a significant part of their net worth from contributions, rollovers from other retirement plans and growth.

Regular IRAs and Roth IRAs have many common characteristics, but there are differences that should be understood. In addition, many have found that converting their regular IRA to a Roth IRA attractive.

The Basics of IRAs

Roth IRA Conversion Opportunity

Tax free distributions from a Roth IRA and no requirement to begin taking distributions at age 72 are attractive. However, to take advantage of those benefits you must pay tax current income tax on the amount you convert. Evaluating whether a Roth conversion is appropriate for you can get complicated and you may want to consult your tax or financial advisor.

Conversion Benefits

Earnings while funds are in both regular and Roth IRAs are not taxable. This enables you to accumulate more than if the funds were in a taxable account. When you take distributions from a regular IRA, they are taxed as ordinary income at rates up to 37%. Distributions from a Roth IRA are not subject to income tax at all for you or the beneficiary of the Roth IRA. This is very appealing.

With a regular IRA, you must begin taking distributions in the year you turn 73. The amount you must take as a Required Minimum Distribution is based the Uniform Lifetime table published by the IRS. For example, the table indicates that a 73-year-old has a distribution period of 25.6 years. To calculate the first Required Minimum Distribution, you take the IRA balance at the end of the prior year and divide it by 25.6. According to the table, for the second year, you would divide the balance at the next prior year and divide by 24.7.

With Roth IRAs, you are not required to take any distributions and your funds continue to accumulate. You can take distributions if you wish. On your death, the beneficiary must begin taking distributions based on their life expectancies. If your beneficiary is much younger the distributions can stretch out for a long time. For example, a child age 40 would have a life expectancy of 43.6 years according to the IRS tables. In that case, the new beneficiary’s Required Minimum Distribution would be the balance at the end of the prior year divided by 43.6. This maintains the tax-free nature of the account for much longer.

Conversion Costs

Like most things in life, there is a cost to pay to get the benefits of a Roth IRA conversion. The cost in this case is paying income taxes currently on the amount your convert. The additional tax you will pay can be substantial if you have a large IRA balance.

Unless you have made non-deductible contributions to your IRA, the entire amount of the conversion would be taxable. This would include what you put into the account and any earnings. The amount converted would be added to your other income for that year and you would pay the tax. This “additional income” would be taxed in your highest tax bracket.

For example, let’s assume you file a joint return and have taxable income of $110,000 and are considering converting $50,000 in your Regular IRA to a Roth IRA. The income tax on the $110,000 would be about $16,100. The additional tax on the $50,000 Roth IRA conversion would be about $11,000. The entire Roth conversion amount would be taxed at your highest marginal tax rate of 22%. This is a lot of additional tax.

In general, you must weigh the value of future tax-free income against the current tax cost for the conversion.

Some Guidelines

• It seldom is advisable to make a conversion if you would have to use funds from your IRA to pay the tax.
• You should also consider your current and expected tax brackets. If you are currently in a low tax bracket and expect your bracket to be higher when would be required to take distributions, conversion is more attractive. Likewise, if you expect your tax bracket to be lower when you retire, conversion is less attractive.
• The longer you can leave funds in the IRA, the more beneficial conversion becomes. If you do not need to withdraw funds while you are alive, enabling it to continue to grow on a tax-free basis for your beneficiary becomes more attractive.
• If you intend to leave your IRA to your heirs and have them named as beneficiaries, making the conversion can increase their benefits. When they inherit your Roth IRA, they would begin taking tax free distributions based on their life expectancies.

Some Caveats

• Be sure to fully understand the benefits and costs when thinking about a Roth conversion. Speaking with your tax or financial advisor may be advisable.
• No one knows what changes may be coming in the tax rules. Increasing tax rates and limiting this conversion opportunity are always possible.