How would a conversion play out financially?
In most cases, if the taxpayer’s incremental tax rate is expected to be the same or increase, and there are funds available outside the retirement accounts to pay the tax, it makes sense to convert. However, we highly recommend that the taxpayer discuss this conversion with a tax adviser, who will run the numbers and help you determine if it makes sense for your situation.
Are there disadvantages to doing a Roth IRA conversion?
Ask yourself: How long until I retire? How will I pay the taxes on the Roth IRA conversion? And do I expect my future income tax rate to be lower than what I currently pay?
First, the more time before you retire and potentially need to withdraw money from a Roth IRA account, the longer that money can grow tax free. Second, a Roth IRA conversion is more attractive if you can pay the taxes from an investment account rather than paying taxes from a retirement account, as withdrawing retirement money generally incurs a 10 percent penalty. Talk to your tax adviser.
Finally, if you expect your tax rate will decrease upon retirement, you may choose to leave your retirement dollars in a traditional IRA rather than converting to a Roth IRA. With the current deficits, many taxpayers are rethinking whether their tax rates will decrease in retirement.
Is there any protection if the converted investments perform poorly?
Basically, the government is offering a mulligan to anyone who converts a traditional IRA to a Roth IRA. If you end up losing money on those converted funds, before Oct. 15, 2011, you can recharacterize the Roth IRA back to a regular IRA. This essentially means you can press reset and put those dollars back into a traditional IRA and you do not need to include the original amount of the conversion in your taxable income. That said, some taxpayers are splitting their conversion dollars into several Roth IRAs so if one performs poorly before Oct. 15, 2011, they can recharacterize that account back into a traditional IRA.
Here is how that could work: You convert $100,000 of traditional IRA money into four Roth IRA accounts containing $25,000 each. Accounts 1, 2 and 3 perform well, with earnings increasing the value of each to $30,000. Account 4 loses $5,000 and is worth $20,000. Before Oct. 15, 2011, account 4 can be recharacterized into a traditional IRA, and the taxpayer does not need to include the $25,000 as taxable income in 2010 or 2011. The other three accounts can continue to grow tax free. It’s a win-win situation.
What questions should you ask your tax adviser when considering a Roth IRA conversion?
Ask your adviser to crunch the numbers to determine whether a conversion is wise, and, if so, how much of a traditional IRA should be converted into a Roth IRA account. Talk to the adviser about how much money you have in retirement savings and how much taxable income you will have in your retirement years. Also consider how much Social Security you will collect during retirement. With these and other variables in mind, an adviser can paint a long-term financial picture and help you determine whether to convert retirement dollars. If it makes sense for you, now is the time to take advantage of tax-free savings. In an uncertain tax environment, locking in today’s rates by ‘prepaying the IRS’ could prove to be a very wise financial decision.
David Shaffer is a director at Kreischer Miller. Reach him at [email protected] or (215) 441-4600.
