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Should you convert your Traditional (pre-tax) IRA to a Roth IRA in 2010?

by
admin
August 3, 2015

Updated: September 1, 2015

The US Congress, in the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2006, eliminated the income limit for conversions from pre-tax retirement accounts (Traditional IRAs (including Rollover IRAs) and 401(k)s, 457s, and 403(b)s) to Roth IRAs as of 2010. Before 2010, your (Modified Adjusted Gross) income had to be less than $100,000 for you to be able to convert. Beginning in 2010, anyone, regardless of income, can convert his or her pretax retirement accounts into Roth IRAs. To avoid having to say pre-tax retirement assets (Traditional IRAs (including Rollover IRAs) and 401(k)s, 457s, and 403(b)s every time, I’ll just refer to all such assets as “Traditional” from now on.)

Should you convert any of your Traditional assets into Roth IRA assets?

Yes, if at least one of the following is true:

  • You expect to pay a higher income tax rate than you do now when you start to draw from your IRA.
    • If you are under 59½ and you would pay the tax on conversion using funds from your IRA, the future rate must be at least 10% higher.
  • You want to make an unusually large contribution to your IRA.
  • You want the greater flexibility offered by a Roth IRA.
  • Your heirs may benefit from the simplicity afforded by a Roth IRA.

No, if none of these reasons applies to you.

Read on for some analysis that will help you think about that question. However, I recommend that you get personal objective professional advice before you make a decision. The rules are complicated, and this brief article can’t address every detail of your situation.1, 2

The table summarizes the major differences between Traditional accounts and Roth accounts.

  1. You see one big difference right away, when you make retirement contributions. With a Traditional, your taxable income does not include your contribution, so contributing will reduce your taxes. On the other hand, withdrawals count as taxable income – withdrawing will increase your taxes. With Roth accounts, you cannot deduct your contributions from income, so your income taxes don’t change if you contribute. Withdrawals from Roth accounts are not taxable income, however: you can withdraw as much as you want without paying any tax later on (after age 59½).
  2. With a Traditional, you must make a withdrawal (Minimum Required Distribution, or MRD) every year after you turn 70½. There are no MRDs for Roth IRAs.3
  3. Once you’ve had a Roth IRA account open for 5 years, you can withdraw your contributions without penalty. A 10% penalty applies on Roth IRA earnings withdrawn before age 59½. That 10% penalty applies to all withdrawals from Traditionals.

So, what does all this mean? Should you convert or not? Several factors are important.

    • If you expect to pay a higher tax rate after you retire than you pay now, you should pay your taxes now, at the lower rate, by converting to Roth. The table at the right illustrates the situation, if you are 59½ or older, and you pay the taxes using funds from your Traditional. In the shaded squares, there is a clear advantage to converting.
      • For example, suppose your tax rate now is 10%, and you expect to pay 35% after you retire. If you have $100 in a Traditional now, and earn a 4% return every year until you withdraw in 11 years, you’d have $38 more with a Roth than if you keep your Traditional (the advantage is 38% of your current Traditional balance).
      • On the other hand, if your tax rate now is 33%, and you expect to pay 25% when you retire, you’d have $12 more in 11 years with the Traditional than if you convert to the Roth (12% of your current balance).
      • If you expect to pay the same rate, you’ll have the same amount whether you choose the Traditional or the Roth. It makes no difference at all.

  • If you are younger than 59½, there is a further complication. Withdrawals from the Traditional to pay taxes incur a 10% tax penalty. So, if you must draw funds from your Traditional to pay the taxes, it makes sense to convert to a Roth and pay the taxes now only if you expect your tax rate in the future to be significantly higher. The table at right shows that rates at withdrawal need to be at least 10% higher in the future to offset the 10% penalty. Again, there is a clear advantage to converting in the shaded squares.
  • Now, suppose you can pay the taxes using funds outside the Traditional. This is just like making an additional Roth contribution. For example, suppose there is $100 in the Traditional, and you are in the 25% tax bracket. If you paid the $25 tax from the IRA (and if no penalty applied), you’d have $75 in the Roth. However, if you have $100 in the Traditional, and you can use $25 of free cash from outside the IRA to pay the tax, you can have $100 in the Roth. In fact, it is advantageous to pay the taxes now even if you expect to pay slightly lower rates in the future: you receive the advantage of tax deferral on more assets. (Again, see the shaded squares for advantageous combinations of current and future tax rates.) For the example we’ve been using, with 4% returns, and 11 years until withdrawal, the Roth has a $4 (4%) advantage even if tax rates on withdrawal are 33% vs 35% now. The advantage is larger for longer waits until withdrawal.
  • Roth conversion has extra advantages if you expect not to need withdrawals from your IRA until later in retirement than 70½. The Roth allows you to defer taxes longer – there are no Minimum Required Distributions. Thus, even if your tax rate analysis suggests rough equivalence between traditional and Roth IRAs, you may wish to convert.
  • On the other hand, if you expect to need some of your IRA assets before age 59½ (say, to pay college tuition), you may also wish to convert some Traditional assets to a Roth IRA in order to take advantage of its greater flexibility. You can withdraw Roth contributions (and conversions) for any purpose 5 years after you open the account.
  • Finally, if you expect that your estate may incur Federal estate tax4, your heirs may have simpler tax returns if you bequeath them a Roth IRA. The Traditional balance includes deferred taxes. Your estate may owe estate tax on these deferred taxes. When your heirs take withdrawals from the bequeathed IRA, they would get credits for the estate tax already paid on the taxes. To get the credits, however, they must remember to apply for them every year! This requires very knowledgeable heirs and very conscientious accountants. With the Roth, there are no deferred taxes, so no need to apply for credits. Much simpler! If your heirs will face much lower tax rates than you do now, more careful analysis is necessary.

In summary, Roth conversion is likely to have substantial advantages unless you expect to face lower tax rates in the future. And, the Roth’s greater flexibility may make it advantageous even if you expect future tax rates to be the same, or even a little higher.

One word of caution: it may be difficult to compare current and future tax rates. Converting to a Roth now may actually reduce your future tax rates (and make Roth conversion less attractive than at first blush!) – you’ll have less future income because Roth withdrawals aren’t taxable income. This effect may be even larger than you might think – reducing post-retirement income enough may reduce the taxed proportion of your Social Security benefits. On the other hand, Roth conversion can increase your current tax rates by pushing you into a higher bracket, thus making the conversion still less attractive.

If you are seriously considering Roth conversion, seriously consider doing a careful analysis – conversion impacts on both current and future taxes are far from obvious.


1As a very simple example, you can’t convert an employer retirement plan like a 401(k) or 403(b) if you still participate in the plan.
2Unless your plan specifically allows qualified distributions before you retire. I told you this was complicated!
3Inheritors of Roth IRAs (and Traditional IRAs) must take MRDs once they inherit the account.
4Currently, there is no Federal estate tax. In 2011, the Federal estate tax reverts to the rules in effect before 2001.

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