Six Factors to Consider Before Converting to a Roth IRA

If you have considered converting funds to a Roth  from a traditional IRA or a qualified (tax-deferred) plan like a 401(k), undoubtedly you have run across this tax code item: in 2010, the income limit for Roth conversions is lifted.  On top of that, the IRS will give you two years to pay the tax on your conversion, with the tax for a conversion in 2010 evenly split, coming due in 2011 and 2012.  You don’t have to split the tax, you could pay it all in 2010 if you like, which might be useful if it would be more expensive to delay the tax.

So – why is this a big deal?  Well, in the past, there has been an income limit of $100,000; meaning that you could not convert traditional IRA funds to a Roth IRA if your MAGI was above that level.

So, back during the bad old Bush days (Remember when?  That was before hope and change…), when the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) was passed in 2001, this particular provision was put into place.  And so, some folks have been looking forward to 2010 ever since (in spite of all of the other tax provisions that are expiring in 2010).

Six Factors to Consider Before Converting to a Roth IRA

If this provision impacts you, it makes good sense to begin planning now for the potential of converting your IRA to a Roth next year.  Here are six factors to consider:

  • If you convert funds from an IRA to a Roth IRA, it is most advantageous if you are able to pay the tax on the conversion from funds outside of your IRAs.  If you can’t do this, realize that any funds used to pay tax on the conversion will also be subject to the 10% early withdrawal penalty if no other exception applies and you’re under age 59½.
  • What is your outlook on tax rates? A Roth conversion, especially when there is a sizeable amount to convert, may be taxed at some very high rates, depending upon your situation.  For example, a couple who would normally have a MAGI of $110,000 would have a marginal 25% rate.  Add in a $200,000 Roth IRA conversion, and a portion of those funds would be taxed at as high as the 33% rate.  It only makes sense to convert if you believe the rates in the future would be higher than the rate you’d pay tax on the conversion today.
  • Does your IRA contain nondeductible contributions?  If, in years past, you have contributed nondeductible amounts to your IRA due to income limits, the Roth conversion of those amounts is a no-brainer for you.  However, you must be careful about how you do a conversion in this case, because any amount that doesn’t represent your nondeductible contributions would be considered taxable upon the conversion. (see Note below for additional explanation)
  • When do you plan to access your funds?  If it’s going to be several years (10 or more) then you will have a better chance of having recouped the tax outlay by way of the tax-free growth in the account.
  • If you need to access the funds from this account much sooner, bear in mind that funds converted to a Roth IRA can’t be distributed for five years after the conversion.  This could throw a wrench in the entire process if you needed access sooner.
  • If you don’t plan to ever access these funds, a conversion may may sense for you, since a Roth IRA has no Required Minimum Distribution.  This way, you won’t have to deplete your IRA balance (after age 70½), and your heirs will reap the benefits of a much larger account, all tax free.

Note: A complication comes up when you have a combination non-deductible contributions and otherwise taxable growth or deductible contributions housed in the same account:  IRA rules require that distributions (including conversions) must be taken out ratably, or in the proportions of the entire account.

For example, if you had an IRA with a $100,000 balance, of which $50,000 was non-deductible contributions, $30,000 was deductible contributions, and $20,000 was growth, then for every dollar that is distributed by conversion, fifty cents would be taxed and fifty cents would be tax-free return of your basis.

One way around this is to rollover the amounts above and beyond your nondeductible contributions into a 401(k), or other eligible plan (but not an IRA), and then convert the remaining amount (the nondeductible contributions) to your Roth IRA.  This would effectively be a tax-free maneuver.  Consult your tax advisor to make sure you’re doing this correctly.

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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