Okay, apologies to Hamlet and Shakespeare. Converting a traditional IRA to a Roth IRA seems to be an ongoing topic of conversation. Why all the focus on converting traditional IRA money to Roth IRA money?
In its infinite wisdom, Congress created this opportunity where anyone can convert money from a traditional IRA or eligible retirement plan into a Roth IRA. Before 2010, if you had adjusted gross income (the bottom number on the first page of your 1040 tax form) under $100,000, you could convert money to a Roth IRA whenever you liked; folks with adjusted gross income over $100,000 were out of luck. But starting in 2010, anyone, regardless of income level, could convert.
So then the question became, well, should you? It helps to understand some of the basic conversion rules and strategies in making the decision. For starters, if you’re over age 70½, you have to take any required distributions from your IRAs and retirement plans first, before you can convert any money to a Roth. The good news though is that once you convert money to a Roth IRA, then you no longer have to take any more required distributions from your Roth IRA.
Next be sure to identify any deductible IRA money (that you’ve gotten a tax break for in the past, by deducting contributions from your adjusted gross income) versus non-deductible money (money you contributed after-tax, where you haven’t yet gotten a tax break). Why the distinction? When you make a conversion to a Roth IRA from your traditional IRA, the IRS requires you to make a pro-rata calculation between deductible and non-deductible money. The reason that matters is you may not be converting exactly what you think.
Let’s say you have a traditional IRA worth $100,000, of which $90,000 is deductible IRA money and $10,000 is nondeductible IRA money. That’s a nondeductible ratio of 10%. If you now convert $10,000 of your traditional IRA money to a Roth, you may think—and want—to convert only the $10,000 of nondeductible money; that makes the most sense because you wouldn’t owe any tax at all then on the conversion. But unfortunately, as far as the IRS is concerned, you’ve only converted $1,000 of nondeductible money. The other $9,000 has to come from your deductible IRA, and when you convert that money, you’ll owe income tax on $9,000 (sorry Ophelia).
Finally, the major downside to converting now is that you have to pay income tax on the appropriate amount you convert. In nearly all cases, it makes the most tax sense if you pay that income tax with non-retirement money (so don’t pay the tax with money from your IRA or retirement plan at work). If you have cash sitting around in a money market fund or a savings account, you’re not losing much by using that cash—because interest rates are so low in late 2011.
Why would you want to consider conversion? It makes the most sense if you expect to be in a higher tax rate in retirement. That higher tax rate could be because you experience wonderful growth rates in your retirement accounts and so you may be faced with larger required distributions at 70½. Or higher tax rates may occur because Congress raises the rates in the future, perhaps to deal with the ever-growing federal deficit. Withdrawals from a Roth IRA in retirement generally come out totally tax-free.
Another reason to convert now (or any point in time going forward) is when a particular investment in your traditional IRA has really plummeted in value, but you still believe it will be a long-term winner. If you’re right, convert that particular asset (x number of shares of stock or a mutual fund, for instance) to a Roth IRA when it’s depressed in value. That lets you lock in your tax payment on that investment at a lower rate. In the future if the investment performs well again, when and if you eventually sell it to pay for your retirement expenses, you won’t owe any tax on that withdrawal from your Roth IRA. In a tax sense, you’ve “paid income-tax low” but then “sold tax-free high.”
In general, if you do expect to pay higher taxes in the future for whatever reason, a good overall strategy is to convert a portion of your traditional IRAs each year going forward. You convert enough to fill up your tax “bucket” for the year, where your bucket is the maximum amount of taxable income you can incur and stay in the same tax bracket. For instance, for a couple who is married filing jointly in 2011, the 25% tax bracket tops out at $139,350 of taxable income. If you expect to have household taxable income (salaries, interest, dividends, etc. less deductions, exemptions, etc.) of say $100,000 for the year, you would convert roughly $35,000 (to be safe) of your traditional IRA to a Roth IRA. Your total taxable income of about $135,000 keeps you in the 25% bucket. If you were to convert say $45,000, that extra $10,000 would push you into the 28% tax bracket.
What if you follow this approach each year and something goes wrong? Maybe the investment you converted falls even further in value, or you have financial emergencies and don’t have the cash on hand to pay the extra income tax from the conversion. You can “undo” any Roth conversion (called a recharacterization) as long as you do so by the due date of filing your return. Translation: you have until roughly April 15th each year (but sometimes longer) to undo a Roth conversion from the prior tax year.
So there’s some of the buzz surrounding Roth IRAs, to convert or not to convert. In some cases, it’s a little more complex than it may seem, so it’s a good idea to run all this by your tax preparer first. But it pales in comparison to understanding Shakespeare, ay? There’s the rub.