Time to Convert to a Roth IRA?

Submitted by David John Marotta on Wednesday, March 28, 2012 - 12:00pm
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A tax tsunami is coming at the end of this year. So this is the last chance to convert to a Roth IRA. At the end of 2010, Congress extended the Bush tax cuts for two years. But the snooze button is running out, and this time the likelihood of another extension is slim.
 
You have just nine more months to convert to a Roth individual retirement account under these lower tax rates and move your money to where it will never be taxed again. In a Roth conversion, you pay taxes on the appreciation in your traditional tax-sheltered account, and then transfer it to a Roth IRA.
 
Regardless of your political persuasion, Congress’ practice of keeping taxes low amid a record national debt and budget deficits is unsustainable. The best we can hope for is gridlock, which would mean the George W. Bush rates expire and return to their previously higher values. Higher taxes are in our future until we get spending under control.
 
The government gave you a tax write-off when you put money into your IRA. Now the government will change the tax rate you pay when you withdraw the money. When you turn 70 1/2, the government requires you to withdraw some of the money from your traditional IRA, known as the required minimum distribution (RMD). You are taxed on it then. 
 
It is as though your IRA has a mortgage on it and next year the government will be raising the rate you pay. A Roth conversion is like paying off the mortgage on your IRA early at these lower rates in order to own your IRA free and clear.
 
Converting to a Roth requires professional assistance from a financial advisor and a certified public accountant. First, determine if you are a good candidate for a Roth conversion. The answer is yes for most families.
 
Advantages of a Roth account: The growth within a Roth account is not taxed, both as it is growing and when you withdraw it. Roths waive the annual RMD requirement. Roth accounts inherited by your beneficiaries are tax-free over their lifetimes.
 
You may be a good candidate for a Roth conversion in 2012 if you can answer “yes” to any of these statements:
 
1.      You expect your tax bill to stay the same or be higher in the future. The level of your income doesn’t matter. If your income is low, you can convert a portion of your IRA at a low tax rate. And if your income is high, your tax bracket in the future is liable to be higher than it is now as the Bush tax cuts expire.
 
If you are working throughout 2012 and then turning 65 and retiring in 2013, you might be better to delay your conversion until you have no income and can convert it all in the lower tax brackets. Delay doing a Roth conversion any time you know your taxable income will be lower in future years.
 
2.      You have an IRA that could be converted. The larger it is, the more essential it is to do a Roth conversion. Because the Internal Revenue Service will force you to start taking RMDs at age 70, those distributions could push you into a higher tax bracket. Converting some of your IRA to a Roth will reduce the value of your IRA and lower the distributions you ultimately will have to take.
 
If you have a 401(k) from a previous employer, you can roll it into an IRA and then convert the IRA. But if you only have your 401(k) from your current employer, moving it to a Roth will probably not be allowed.
 
3.      You have sufficient assets to pay the tax from your nonretirement accounts. You lose many of the benefits of a Roth conversion if you pay taxes from your IRA account rather than from your taxable assets. This is one reason we recommend putting 5% of your take-home pay toward taxable investments.
 
4.       You want to reduce your estate’s value and leave a tax-free asset to heirs. Converting your IRA to a Roth and then leaving it to grandchildren could produce an after-tax benefit twice as large as leaving them the traditional IRA and the taxable amount that could have been used to pay the conversion tax.
 
5.      You are willing to pay estimated taxes and incur increased tax preparation fees. The conversion slightly complicates your tax preparation, which is why we recommend you engage competent financial advice.
 
You can reverse a Roth conversion as late as Oct. 15 of the following year. So the more time you allow yourself between now and Oct. 15, 2013, the more time you will have to determine if the funds you converted to a Roth did well. If the Roth IRA dropped in value, you may want to un-do the conversion, known as recharacterizing. If the account held its value or grew, stick with the Roth.
 
David John Marotta, CFP, AIF, is president of Marotta Wealth Management Inc. of Charlottesville, Va.
 
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