Roth Evangelists Preach to the Unconverted : A Key Deadline Looms for Those on the Fence

Still trying to decide whether to convert your traditional individual retirement account to a Roth? You have plenty of company.

Financial experts say millions of Americans have been considering this vexing question for months. But if you hope to take advantage of rules allowing you to spread out the tax hit that conversions inevitably create, the time for action is near.

“There’s a special opportunity for those who do this just in 1998,” says Tim Kochis, a partner at San Francisco-based financial planning firm Kochis & Fitz. “If you want that benefit, the sooner you convert the better.”

Roth IRAs, created in 1997’s tax law overhaul, provide no upfront tax deductions. But if you follow the rules, you can withdraw money tax-free. Traditional IRAs work in the opposite way: You get deductions when you put the money in but must declare it as taxable income when you take it out.

Taxpayers who already have traditional IRAs have the option of converting them to Roths. However, if you convert, the amount you pull out of the traditional IRA must be declared as taxable income.

Generally, all the converted money must be claimed as income in the year of the conversion, but there’s a special exception for those who convert before the end of this year. They get to spread the income--and therefore the tax bill--over a four-year period.

That tax break is the equivalent of getting an interest-free loan from Uncle Sam. Better yet, if you have a substantial account, dividing the funds into four piles helps keep your annual income lower and lowers your chances of being bumped into a higher tax bracket.

Consider John Saver, a hypothetical 40-year-old single taxpayer who earns $30,000 annually and has an IRA worth $50,000. All of the principal of this IRA was deductible going in, and the entire amount is taxable when coming out. If Saver converts the $50,000 to a Roth in 1999, he must take the entire $50,000 as income that year. That pushes some of his income into the 31% federal tax bracket and ends up costing him about $14,200 in federal income tax.

If, however, he converts in 1998 and chooses to spread the income into four installments of $12,500 each, some of his IRA income is likely to be taxed at 15% and some at 28%. The bottom line: The total increase in his tax bill as the result of conversion amounts to about $13,200--or $1,000 less than if he converted all at once.

So the question remains, should you or shouldn’t you convert? To decide, you must consider four things, experts say.

1. Do you qualify? The only taxpayers who can convert a traditional IRA to a Roth are those who earn less than $100,000 annually, regardless of whether they’re single or married. If you earn more and don’t have the ability to reduce your income by, say, postponing a bonus, stop agonizing now. You can’t convert.

2. Can you pay the additional tax bill without tapping the IRA money to do it? “Don’t do it unless you have the cash to pay the tax with non-retirement money,” says Janet Briaud, a fee-only financial advisor in Bryan, Texas.

If you are younger than 59 1/2 and tap your IRA funds to pay the tax, you’ll get hit with a penalty amounting to 10% of the amount you failed to roll into the Roth, says Mark Luscombe, principal tax analyst with CCH Inc., a Riverwoods, Ill.-based publisher of tax information. Also, less of your money goes back to work for you, making the tax-free income generated in the Roth less valuable.

Indeed, Kochis’ firm has run dozens of mathematical models to see whether it’s ever beneficial to use IRA funds to pay the conversion tax. In every instance, the taxpayer was no better off converting than if he or she had left the money alone, Kochis says.

3. Can you leave the funds alone for at least five years? If you need to tap the Roth IRA within five years, you would be subject to tax penalties and your money would not have enough time to generate tax-free investment earnings to make the conversion worthwhile, experts agree. Unless you’ve got more than five years before you’re likely to need the IRA money, don’t convert.

4. Will you jeopardize other tax breaks by boosting your income above applicable thresholds if you convert? One numbingly complex aspect of the U.S. Tax Code is that there are a host of income-contingent tax breaks. For instance, there’s a child tax credit that reduces the federal income tax paid by parents with qualifying dependent children by as much as $400 per child in 1998 and as much as $500 per child in 1999. But if your income exceeds certain thresholds--$75,000 for singles, $110,000 for married couples filing jointly--you lose all or a portion of this credit.

Likewise, there are sizable credits available to people who pay to send their kids--or themselves--to college. But these credits--worth as much as $1,500 in tax savings annually--start phasing out once a married couple’s income exceeds $80,000 or a single person’s income passes $40,000.

If converting your traditional IRA to a Roth will jeopardize your ability to claim either of these credits--remember, your taxable income will be boosted by the amount of IRA money you convert--you might lose more in a conversion than you’d gain.

How do you know? Either consult a tax advisor or run a projection yourself by penciling out your numbers on a 1040 form. (If you don’t have one handy, you can get one from the Internal Revenue Service’s Web site at https://www.ustreas.irs.gov.)