In 2010 the rules for doing a Roth IRA conversion were liberalized, making it an option for all income brackets. Previously there was a $100,000 Adjusted Gross Income limit for those wanting to convert. If you are contemplating a Roth conversion this year here are the basics for you to consider:
Roth Conversion defined
A Roth IRA Conversion is when you take a traditional IRA and convert to a Roth IRA. This is a taxable event as any pretax money within the traditional IRA will be taxed as ordinary income. The benefit is all future growth within the Roth IRA will be tax free when distributed in retirement.
When should you consider a Roth conversion?:
- your tax rate now is estimated to be less than in retirement
- you have sufficient time before retirement to let the funds inside the Roth grow before taking distributions
- you have outside funds to pay the taxes that will be due on the conversion (if less than 59 1/2, but really a good idea for any age)
- you are interested in using it as an estate planning strategy to leave to heirs.
When you should think twice about doing a conversion:
- you are currently in the highest income tax bracket and will probably be in a lower one during retirement.
- you will have to use the cash from the IRA to pay taxes, thus triggering an additional 10% penalty (< age 59 1/2 withdrawal).
- you are already retired and the conversion will increase your AGI thus increasing the taxation on SS benefits for that year.
- your child is applying for financial aid at school, a large conversion will increase your household income thus disqualifying aid chances for the year.
- you intend to use the IRA assets to pay for health related costs in retirement.
The Roth IRA conversion option can be a great tool as you plan your retirement, just be sure to consider all the pros and cons before moving forward.
One special note: an often overlooked item for those converting a Non Deductible IRA with “basis” (your out of pocket contribution) is that they automatically assume that no taxes will be due on the “basis”. When converting an IRA to a Roth you have to divide the basis of that IRA by the combined total value of all of your IRA’s (traditional and rollover) to get a percentage which is then multiplied with the amount of conversion to figure your allocable basis and income on which taxes will be due. If this sounds complicated seek out help from a financial planner or CPA prior to making the conversion.