Be Smart about the Roth Conversion

Originally published 4/16/2010 at the Financial Planning Association's All Things Financial Planning Blog

Roth conversions have increased this year, thanks to the elimination of qualifying income limits. But on the flip side, so have mistakes, according to recent articles in Financial Advisor magazine and by personal finance columnist Humberto Cruz.

What do investors need to know before deciding if a conversion makes sense?

Because of the complexity and the assumptions made, potentially a lot. Many are cheerleading the Roth conversion, but truthfully it will require a thorough analysis and education prior to a decision.

Like a successful round of golf that requires planning to realize its potential, so does creating a successful conversion. To realize the potential inherent in a Roth, here are just a few considerations to keep in mind:

1.When to pay the green fees. When you convert, taxes will be owed. Advisors typically recommend paying them with assets held outside of IRAs, which may require estimated taxes to be paid. In 2010 you have the option of paying the taxes on the Roth in the year of conversion or splitting the tax over the following two years. Although at first glance it may seem wise to defer the taxes due, a number of factors here require personal planning, not the least of which are assumptions about future tax rates.

2.Best ball. One strategy that your advisor may propose is converting the Roth into multiple accounts to see which landed on the fairway and which landed in the rough. Any that were not worth the cost of converting can be undone–more on this idea below.

3.Play 9 or 18? Many people mistakenly assume they must convert their entire IRA into a Roth Conversion IRA. These investors may be ignoring the tax-planning ramifications of a partial conversion or believe they need to convert all or nothing.

After the conversion, don’t forget your secret weapon: the mulligan, which in casual rounds of golf allows you to replay a stroke.

We all know that life and the IRS don’t allow too many do-overs. But with the new rules, you actually have the opportunity to undo the conversion if it turns out to be unfavorable. Called a “recharacterization,” this strategy literally allows you to change your mind up until your tax-filing deadline.

All of the implications of the Roth conversion are too detailed to describe here, and there is generally few clear-cut cases whether or not you should convert.

Keep in mind too that many in their haste to convert have forgotten that the Roth conversion is not a personal finance free lunch; it is, in fact, a federal tax revenue raising strategy.

So don’t just convert mindlessly. Know the layout of the course and have a plan before converting.


About the author

Robert Schmansky, CFP®

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