Converting Your IRA to a Roth Account Could Be a Smart Move--Especially in ’98

Q: I am seriously thinking about rolling over my existing individual retirement account into a Roth IRA when the new accounts become available next year. As far as I can tell, this is a fabulous deal. Don’t you think so?

--L.S.P.

A: You’re right; converting your traditional individual retirement accounts to a new Roth IRA can be a smart move. But you’ve got to know what you’re getting into first.

The Roth IRA has generated considerable enthusiasm among taxpayers because it offers them a chance to accumulate retirement savings that can be withdrawn tax-free (under specific conditions).

Quickly, here’s how it works: You can contribute up to $2,000 per year from your after-tax earnings. To qualify for tax-free withdrawals, you must hold the account five years before taking out any money. That period begins the first year in which an annual contribution is made.

You also must be at least age 59 1/2 when the distributions are made, unless the distributions are made after death, because of disability, or for a qualifying first-time home purchase (up to a lifetime maximum of $10,000).

You can contribute to a Roth IRA only if your income is less than $95,000 if you’re single, or $150,000 if a married couple filing jointly.

There are no mandatory distribution ages or amounts; you may hold the account for as long as you want.

In fact, it could even become part of your estate. Withdrawals made for higher-education expenses are not subject to the 10% penalty for early withdrawal, but they are subject to ordinary income taxes to the extent that the withdrawals exceed the amount contributed to the account.

What makes converting your traditional IRA to a Roth most appealing is the fact that next year--and only next year--the government is offering taxpayers a chance to spread payments for the tax bill from the conversion over the next four years.

What does this mean? Simply that if you convert your traditional IRA to a Roth in 1998, a process that involves withdrawing the funds and subjecting them to taxation at your current income rate, you may pay the tax bill over the next four years.

John Coscia, director of sales and marketing for retirement planning at Merrill Lynch, says a conversion makes sense if taxpayers can meet the following three conditions:

* They expect to be in the same or greater tax bracket during retirement as they are in now.

* They are able to hold the Roth IRA for a minimum of five to seven years.

* They are able to pay the taxes due from the conversion without dipping into the IRA account.

“The worst thing you can do is to pay the taxes out of the principal,” says Coscia. “It reduces the amount on which you can be earning tax-free interest and it potentially subjects you to early-withdrawal penalties on the funds you use.”

Coscia says Merrill Lynch has tested hundreds of potential scenarios involving conversions, and all lead to the conclusion that the amount involved in the transfer doesn’t matter as much as the individual’s tax bracket and how long he or she intends to hold the account.

He says most conversions will pay for themselves within five years. So that means if you hold your Roth IRA at least five years, its tax-free withdrawals will be more valuable than the taxes you paid at conversion.

A critical consideration, Coscia says, is the government’s offer to spread the tax payment over four years. Conversions after next year will require taxpayers to pay the tax on the IRA withdrawal all at once.

What does this mean now? It may mean that you should take steps to ensure that you will not exceed the income limits in 1998. The amount of money converted from one IRA to the other does not count toward this limit.

However, these funds may push you into a higher tax bracket and cause a loss of certain deductions or exemptions, so these conversions are worth a great deal of thought, study and consultation with a trusted advisor.

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Q: I am fully retired, over age 70 1/2 and still receiving deferred compensation from my previous employer. It is reported to the Internal Revenue Service on a W-2 form. Does this income count toward my eligibility for opening a Roth IRA? May my wife, who does not work, open a nonworking-spouse Roth IRA as well?

--C.W.

A: We can’t respond with absolute certainty, but if your deferred compensation is derived from what is called a non-qualified plan, it is not considered earned income. As such, it does not count toward the earnings you need to open a Roth IRA or a traditional IRA for either you or your wife.

By the way, payments from pensions and annuities also do not count as earned income.

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Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or e-mail carla.lazzareschi@latimes.com