Traditional vs. Roth IRA - Is a Conversion Right For You?
The Individual Retirement Account has been around since 1974, and the Roth IRA since 1998 — long enough for millions of Americans to build substantial savings to supplement income from Social Security and employer-sponsored plans for their retirement years.
Their basic structure hasn’t changed over the years. In general, with a traditional IRA, contributions are made with pre-tax income, and withdrawals are taxable, while contributions to a Roth are made with after-tax income and withdrawals are not taxable.
But two significant changes in the rules have occurred this year, so anyone holding a traditional IRA might consider converting some or all of the funds of a deductible or nondeductible traditional IRA into a Roth.
As of January 1, the $100,000 limit to modified adjusted gross income (MAGI) for converting traditional, rollover, SEP and SIMPLE IRAs, and 401(k) and other workplace plans into a Roth IRA has been eliminated.
In addition, anyone making the conversion this year can choose an intriguing tax option. Pay taxes on the amount converted (remember, withdrawals from non-Roth IRAs are taxable) on your 2010 return, or defer and divide the tax bill, paying income tax on half the conversion in 2011 and on the other half in 2012.
The change to the income limit opens the door for conversions by those with six-figure incomes. The tax-deferral option could make a conversion more appealing to someone who might balk at paying all the additional tax on a significant sum at one time.
Those are the basics. Now, what considerations should you factor into your decision-making?
Do you expect to pay higher taxes in the future? If you do, then it could make sense to convert now, pay taxes on the amount converted, and not have to worry about paying taxes when you start making withdrawals from your Roth. Don’t forget that taking taxable withdrawals from a traditional IRA might push you into a higher tax bracket at some point in your retirement years, but that can’t happen with a Roth.
Making the right decision on the tax question may depend on your ability to see into the future. Conventional wisdom is that, in retirement, your income should be lower, so therefore your taxes should be lower too. However, that’s not true in every case.
Furthermore, unless Congress acts this year, tax brackets above the 15% bracket will revert to their pre-2001 levels. The top four brackets — now 25%, 28%, 33% and 35% — would move up to 28%, 31%, 36% and 39.6% in 2011. In addition, while the Obama administration has proposed raising tax rates only for those earning $250,000 or more, it is difficult to predict how Congress might act if additional federal revenues are needed in these hard economic times.
Can you afford to pay the taxes now? If you make the conversion, you will want to pay the taxes from your non-retirement cash reserves. For instance, if you roll over $100,000 and you’re in the 28% tax bracket, you’d owe $28,000 in taxes this year, or $14,000 in 2011 and $14,000 in 2012. Using funds from your traditional IRA to pay taxes on the conversion would reduce the amount that you’d have working for you tax-free in the Roth account.
How long is your investment time frame? The longer your investment horizon, the more likely you are to see the benefits of your retirement fund growing tax-free inside a Roth IRA. Once you recover from the taxes paid on the conversion, you won’t have to worry about paying taxes on withdrawals. Also, if your traditional IRA is worth less now than it was a couple of years ago (and you expect your investments to recover), the cost of converting now could well be less than a few years ago or a few years down the road.
There are some other advantages to a Roth IRA that may make a conversion worthwhile.
For example, with a Roth, you don’t have to start taking withdrawals (required minimum distributions) when you turn 70½ as you would with a traditional IRA. This gives you more flexibility in managing your retirement funds. The beneficiaries of your Roth IRA also will enjoy tax-free withdrawals but they will be required to take regular distributions.
As appealing as these benefits may seem, the conversion isn’t for everyone. If you can’t afford the tax payment, or if you’re within a few years of retirement, the conversion might not be a good idea.
Weigh the pros and cons, estimate the tax consequences, and discuss any questions with your financial advisor. Making the right decision will increase your security as retirement nears.
By: John Fay, CPA
John Fay is a tax director with Horty & Horty, P.A., a Delaware accounting firm with offices in Dover and Wilmington.