Should you convert to a Roth IRA?
Responding to a widespread clamor for better access to Roth IRAs, the federal government is lifting some restrictions on them and giving a tax break to those who choose to convert a conventional individual retirement account to a Roth in 2010.
The changes have some advisors extolling the virtues of these retirement accounts and urging their clients to take advantage of this “once-in-a-lifetime opportunity.”
But other experts warn that the conversion decision is far more complex than it might appear and may be less attractive than you think.
What’s this all about? Here are some answers for the 37.7 million Americans with IRAs, especially those who might want to switch.
What’s a Roth IRA?
A Roth is a tax-sheltered retirement plan.
A conventional IRA gives you upfront tax deductions for the money you contribute but levies tax on every dollar in the account -- both principal and investment returns -- when you pull money out at retirement.
In contrast, a Roth provides no upfront tax deductions for your contributions but promises that every dollar pulled out of the account when you retire is tax-free. That’s attractive to those who expect to be richer -- or expect tax rates to be higher -- when they’re retired.
Another benefit of the Roth is that no one requires that you withdraw money from it -- ever. What’s the advantage to that?
Estate planning. With a conventional IRA you have to start taking money out after the age of 70, and it’s taxable. With a Roth, you can leave your heirs a pile of tax-free dough if you’re really rich and don’t need it when you’re alive. One caveat: All of your assets are potentially subject to estate tax when you die.
Why the hubbub now?
Roths are most attractive to two groups -- young people who are in low tax brackets now but expect to earn more in the future and high-income taxpayers who have been put on notice that the Obama administration plans to hike tax rates on the rich.
But rich taxpayers have been largely locked out of Roths because tax rules won’t let them contribute to one if they earn more than $120,000 if single or $176,000 if married. And those who want to convert a conventional IRA to a Roth were blocked if their adjusted gross income exceeded $100,000.
The income restrictions on people wanting to make new contributions to a Roth remain. But starting in 2010, anyone can convert a conventional IRA to a Roth, regardless of income. Moreover, those who convert in 2010 will be able to defer the income tax hit that a conversion creates, applying it to 2011 and 2012.
Why does conversion create an income tax hit?
You essentially have to close your conventional IRA and declare all the money in it as income before redepositing those same funds into a Roth IRA. That IRA “income” can sometimes push you into a higher tax bracket, which can make conversion costly.
For 2010, however, Uncle Sam has a deal for converts. If you trade in your conventional IRA for a Roth this year, you can split the income generated by the conversion and apply half to 2011 and half to 2012. That means you would delay paying the income tax on the deal for up to two years.
That sounds like a great deal. Does that suggest people should convert in 2010?
The deal may sound better than it really is, said Rande Spiegelman, vice president of financial planning at Charles Schwab & Co. in San Francisco.
“Normally, deferring income is a good thing, but there is always an exception,” Spiegelman said. And this is likely to be it.
If you are a high-income taxpayer -- as are most of the people who are newly allowed to convert -- you’re likely to face higher income tax rates in 2011 and 2012 than you do now because of tax hikes that the government is planning.
If you wait until 2011 or 2012, which the government assumes unless you say otherwise, you’re likely to pay more tax on this income than you would have if you paid the tax in 2010.
The Internal Revenue Service assumes you will make the choice that generates the most tax money for the government, Spiegelman said. “If you expect that your bracket is going to go up, accelerate the income to 2010.”
How do I figure out whether it makes financial sense to convert and pay tax now on money that I otherwise wouldn’t have to pay tax on for decades?
That is the question of the hour. Experts say it is extremely difficult to work out the math on this conundrum because you have to make lots of assumptions. For a conversion to make sense, you have to assume four things:
* That you’ll pay the tax obligation created by the conversion in cash, not by draining your IRA assets.
* That you’ll have many years to accumulate tax-free earnings before you’ll ever want to access this money.
* That you’ll pay higher tax rates in the future than you do now.
* That Congress will not renege on the promise never to tax Roth IRA assets.
Even then, there may be situations in which the conversion doesn’t make sense. Many of the major brokerage and mutual fund firms, including Schwab and T. Rowe Price, offer Web-based calculators designed to help you decide which choice would land you the most retirement money in the end. But experts acknowledge that there are so many unpredictable factors involved in the decision that it’s impossible to be certain that one answer will result in more than another.
“There are a lot of unknowns and no one-size-fits-all answer,” said Stuart Ritter, assistant vice president and certified financial planner with T. Rowe Price, a big mutual fund company based in Baltimore. “It’s definitely not an easy decision.”
Can I split the difference by converting only some of my IRA assets?
Yes. And this can be a smart approach if you think you have more IRA money than you need. If you think you’d like some Roth money -- so that you have the option of leaving it to heirs or simply because you like the notion of having some tax-free income in retirement -- you can manage your immediate tax hit by converting just a portion of your IRA assets each year.
