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Four Factors to Consider Before Roth IRA Conversion

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Retirement Nest EggsNow that the income limitations have been lifted and anyone can convert a tax-deferred Traditional or Rollover IRA into a tax free Roth IRA, a lot of blogs, gurus, and news sites have been celebrating the Roth IRA conversion. I have always held the Roth IRA in high regard because it’s a fantastic retirement investment vehicle that offers a little more predictability. I pay taxes on my contributions today and I get all the appreciation tax free, what’s not to love about it?

Unfortunately, whether or not you should convert a Traditional or Rollover IRA to a Roth IRA is not as clear cut. There are a lot of important factors many people are overlooking when it comes to Roth IRA conversions. While you may gain some tax benefits in your retirement assets, it does come at a cost to your overall financial picture. To ignore those could be extremely detrimental. Let’s take a look at the four major factors to consider before you convert to a Roth IRA.

Tax Implications of More Income

When you convert your Traditional IRA to a Roth IRA, the amount you convert will be recognized as ordinary income. Think about the tax implications of your conversion because if you have a sizable nest egg, it can have a huge impact on your taxes. For example, if you earn $50,000 a year and you convert a $100,000 IRA, you will move from the 25% tax bracket all the way to near the top of the 28% tax bracket. The tax brackets don’t look quite so large when you are converting an IRA you’ve spent many many years accumulating.

There are a lot of tax deductions and credits that get phased out over you enter those higher tax brackets. For example, the student loan interest deduction starts to phase out at $55,000 ($110,000 for married filing jointly). Other services are also affected by this increase in ordinary income, such as financial aid and the tax treatment of Social Security. You will want to take these phaseouts into consideration before converting your to a Roth IRA.

Tax Profile Diversification

It’s a well known fact that tax rates have been the lowest they’ve been in quite some time but that doesn’t necessarily mean that converting today is the right move. For starters, it’s unclear how taxes may be changed going into the future. For example, should we move towards more of a Value Added Tax, which is like a sales tax at every step of the production process, you could see more of the tax revenue shift from income to VAT. As it becomes more politically dangerous to float tax increases on income, we may see more creative taxing mechanism that doesn’t rely on income tax.

The conclusion is that given future uncertainty, we may want to build some tax diversification into our retirement accounts. Just as you don’t want every dollar to be tax deferred, you don’t want every dollar tax free. Who knows what the tax structure will be in the future and to assume your tax rates will be higher may be a mistake. Having an even mix of the two might be the best plan going forward.

Think Twice If You Can’t Pay Tax

The general consensus is that you should only convert if you can pay the income tax with non-retirement funds. The reasoning is that if you pay the taxes with your retirement funds, you are setting yourself back a few years. With 401(k) contributions capped at $16,500 a year (lower the last few years) and IRA contributions capped at $5,000 (also lower the last few years), taking a big chunk out for taxes is going to hurt you more than the tax benefits will help you. So if you cannot pay for the taxes with non retirement funds, it’s recommended that you avoid converting.

If You’re Near Retirement…

It’s hard to predict what tax rates will be in thirty or forty years, but the likelihood that they will be significantly higher or lower in the next five is fairly slim. That being said, if you believe that the rates will go up before you hit retirement or if you will reach the age of required minimum distribution on your Traditional IRA (and you don’t want to take the RMD), then you’ll want to convert. If you don’t think they will go up and you’re retiring in a few years, you might want, for reasons of stability, keep things the way they are. This isn’t a big reason not to convert your Traditional IRA to a Roth IRA but it’s one you should think about (which is why it’s the last one listed). If your rates won’t change, then converting only costs you some time (and any fees).

(Photo: scottwills)

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44 Responses to “Four Factors to Consider Before Roth IRA Conversion”

  1. Chuck says:

    Also, consider you’ll probably want to fill in your 0% and 10% (and maybe 15%? Depending on your income now.) brackets throughout the duration of your retirement with tax-deferred money instead of Roth money. For most people, this means not converting a substantial portion.

    At today’s rates, you can earn up to about $20K with almost no tax. If you plan to be retired for 30 years, then it makes sense to have 600K in unconverted funds when you start retirement.

    I plan to convert to Roth if/when I get fired. :)

  2. Jim says:

    I agree totally with Chuck’s point.

    I’d say the first part of your retirement up to ~$500k-600k range should be in taxable accounts so you can take advantage of your standard deduction and exemption during retirement.

  3. Pop says:

    And remember that people who convert this year are able to spread the tax bill over two years (paying in 2011 and 2012) instead of paying all at once.

  4. jsbrendog says:

    hopefully i don’t lose my job so i wont have to worry about taking the 401k with me. scary thought.

  5. MoodyBlue says:

    Missing in all these analyses is the idea that (particularly a Democratic) Congress will take a look at that large pot of Roth IRA money, and say “You know, I’d like some of that.”

    I’m betting that will happen, so I’m keeping quite small amounts in Roths.

    • NateUVM says:

      Cynically, if they WERE to try and tax what was in a Roth, the worst they could do is treat the withdrawals the same as what was in a 401(k) or traditional IRA account. I mean, why would they tax it any harsher? So, I’m not sure why you would specifically avoid Roth IRA/401(k)s on that basis.

      Furthermore, unless Congress REALLY wanted to start a firestorm, they would only be able to tax the earnings because the principle (contributions) would’ve already been taxed. So, you’re still not going to pay taxes on the whole balance.

      So I guess I’m still not really sure what the risk in diversifying your tax risk in a Roth is? Even if they change the tax laws akin to the EXTREME example you elicit, you’re still not going to be worse off than if you hadn’t invested in a Roth in the first place, right?

      • MoodyBlue says:

        I’m afraid you’ll be worse off:

        First, you’ll pay taxes now, when you make a conversion. Then, you’ll pay taxes again when you withdraw the money (in my ugly scenario).

        It could be worse. Before it was repealed when the Republicans took over in 1995, there was a limit (an excess accumulation) that you could have in IRAs and other tax-advantaged accounts. It was about $1.35 million back then. ‘Excess’ money was subject to a yearly ‘excise tax’. This could return.

        Finally, there’s no rule, constitutional or otherwise, that says Congress must treat Roths like any other IRA or any other kind of income.

        It’s possible that, even if Congress decides to ‘start a firestorm’, that it will only affect the ‘rich’, anyway. However the ‘rich’ are defined.

        • NateUVM says:

          You’re right, Congress COULD chose to pass any new tax that they want, like taxing breathing, but I don’t think that’s going to happen. Just like they aren’t going to all of a sudden start taxing you on funds that you have already paid taxes on, like the cost basis in a Roth Conversion.

          No, I think that the only thing at risk of being taxed in the future, thus negating the benefit of the Roth, would be its earnings. Anything more, and they may as well go after all different types of accounts, and not just Roths. Because there would be nothing special about Roths at that point.

          Then again, I still don’t think they’ll be taxing breathing anytime soon, either.

    • freeby50 says:

      Theres no way that congress is going to tax Roth accounts. That would be taxing it twice and voters wouldn’t go for that ever. Even if you think it would happen then you’d be no better off with other investments. If they double taxed Roths then theyd’ be able to double tax everything else and your money wouldn’t be safe anywhere.

      • MoodyBlue says:

        I hope you’re right.

        Though, there’s nothing unusual about taxing money twice.

        You pay income tax on the money that’s withheld for Social Security; if you get dividends from owning stock, it’s taxed once at the corporate level and once for you.

  6. govenar says:

    Most of the stuff I read about this is about converting an existing traditional IRA. If I don’t currently have a traditional IRA, and I can no longer contribute to a Roth IRA due to being over the income limit, is there any reason to not open a traditional IRA, contribute $5000 of after-tax money to it each year, and convert it to a Roth IRA each year?

  7. MoodyBlue says:

    Yes, you can.

    This strategy, while permitted, really doesn’t seem to make sense. It’s an extra step, but that’s how the 2010 rules stand.

  8. reinkefj says:

    One small factor to consider is the recent rumor about the Gooferment needing to sell bonds, China doesn’t want to buy them, and the Gooferment turns to the IRA / 401K accounts. Take them in exchange for an “enhanced” Social Security payment. Don’t dismiss it out of hand because it would be simple for them to “execute”. All IRAs and 401Ks have a “custodian” that can have their arm twisted. I’m sure the folks here in the USA prior to the “gold seizure” didn’t think that could happen either.

  9. TJM says:

    You might want to add AMT as another factor. If you owe AMT you may actually benefit from converting. If your income rises enough, it may negate the need to pay AMT reducing the net tax obligation.

  10. pmulroy says:

    It is not too outlandish to think that democrats will be unable to restrain themselves and go after the huge pot of Roth IRA money out there. Of course they will have to sneak it in through the back door through something like what MoodyBlue was describing (excise tax on accounts over a certain amount, only hurts the “rich” and those “best able to pay”).

    This is the problem when democrats try to raise money for new programs/entitlements and they decide to tax the “rich”. As residents of high income/cost states like California or New York are finding out, the “rich” aren’t old white guys in Texas sitting on vast oil fields. Instead the “rich” are regular folk who happen to hold down a productive job or their own business and every year the government comes after them for ever increasing amounts. If a program is really for the benefit of a whole society, shouldn’t everyone in that society have to pay for it? Instead, voters want all the programs/entitlements that democrats dangle in front of them and will keep believing that the “rich” will be paying for it until it the day a new tax bill smacks them in the head. Exhibit A is the union outrage over Obama trying to tax “cadillac” health insurance plans. Ooops, I guess union members didn’t like that democrat definition of the “rich” who should be paying more taxes.

    I remember reading a saying that goes along the lines of “If you are not a liberal by 18, you have no heart. If you are not a conservative by 30, you have no brain.”

    • NateUVM says:

      Trying to get a read on where you are going with this… Are you for labor union’s “cadillac” health care plans, or are you for Obama policy proposals?

      Or, is it just “No” to both? You seem to be straddling the fence, there.

      • pmulroy says:

        NateUVM,

        I’ll try to be brief as Jim’s post wasn’t about healthcare, it was about Roth IRA conversions.

        1)Linking health insurance to employment in the USA has been described as a “historical accident” and is a large reason health insurance is dysfunctional in this country.

        2)Definitely against Obama/democrat proposals as presently written. My health insurance is expensive enough, I don’t see why I should be expected to pick up the cost(via increased taxes on the “rich” and higher premiums) for other people who don’t want to contribute a dime (via across the board tax increases or buying an individual policy) for their own health insurance.

        • saladdin says:

          Right! Damn those poor people making 7.25 an hour. They deserve no health insurance so they will die out quicker and leave the best people to populate the world.

          saladdin

          • Rob says:

            This is a poor attempt at sarcasm. The poor people you describe are already eligible for Medicaid thanks to Joe Taxpayer.

            The plain and simple fact is that only a fraction of the 46 million that are supposedly uninsured actually fall into this category. First of all, 46 million uninsured refers to anyone who was uninsured during a reference year, whether for one week or the entire year. The number is significantly smaller when you exclude those that are uninsured for only a short time.

            Of the remaining “uninsured,” a large portion falls into one of the following 4 categories:

            1) 7-8 million of them were Medicaid recipients.
            2) 10-20 million are not legal U.S. residents.
            3) 60% of the uninsured are under 35, 86% of whom are in good-to-excellent health.
            4) As many as 75% of those uninsured could afford health insurance, but choose not to. Over 45% of these people live in families making over $50k/year and over 23% of these people live in families making over $75k/year.

          • saladdin says:

            Rob,

            I work in a building with 110 others with an average rate of 9.35 an hour. Family coverage is 350 a month which is an entire paycheck. This is where quoting all your statistics falls short of the real problem. They make too much for gov help and not enough to pay premiums.

            saladdin

          • Rob says:

            saladdin- I could not reply to your most recent comment, so I replied here.

            You seem to describe the perfect scenario where someone wouldn’t qualify under Medicaid. Let’s look at this “perfect” scenario. This scenario assumes that none of these people have write-offs of any sort; otherwise, they would be eligible with even minimal write-offs.

            It also assumes both of the following:
            1) A single-income household (otherwise, family income would be significantly more than you are stating) and
            2) Three or fewer family members (otherwise, the family would meet the Medicaid income eligibility requirement).

            I’m going to go out on a limb and assume that all 110 people at your company don’t make $9.35/hour…some make more and some make less. Even with no write-offs, a 3-person family, and a single-income household, someone making roughly $8.80/hour would still be eligible for Medicaid.

            Plus, there are all kinds of scenarios where the bar of eligibility is lowered even further (pregnant women, children under 6, adults over 65, whether or not you are “medically needy” as determined by your state, etc.).

            Given all these factors, it wouldn’t be a stretch to believe that the vast majority of employees at your company are eligible under Medicaid or have lower health insurance costs and/or higher incomes than you state.

            All this aside, history and statistics show that there is upward mobility between tax brackets. A person’s income tends to rise as he/she gains more work experience. In other words, people don’t spend year after year stuck in the very small, highly unlikely scenario you are describing.

            On a personal note, I recently looked into purchasing private health insurance. I found 18 plans that could be purchased for less than $80/month. Most people pay nearly that or more for their cell phones every month.

          • govenar says:

            In response to Rob: I took a quick look at US census data, which says the average household size is around 2.6. So it sounds like it’s pretty common for a household to have fewer than 3 people.
            Also, the average cell phone bill is around $50, not $80 (and probably even lower for poorer households).

          • Anonymous says:

            govenar-
            I think you missed my point. Medicaid eligibility isn’t measured in fractions of people. Also, the average US family isn’t a single-income household living off $9.35/hour. So using averages for the entire US population gives us little or no insight on the 110 people saladdin works with.

            My point was that in order for one of the households that saladdin describes to be ineligible for Medicaid, it would have to be a single-income family consisting of 3 people (no less, no more) with no write-offs.

            And my point regarding cell phones was one of priority, not necessarily one of direct comparison. Even the lowest individual plan by major cell phone carriers costs approximately $50/month after taxes and fees (and significantly more for additional lines). What I didn’t mention was that I was being conservative in my $80/month statement. I found a handful that were in the $60-65 range also. Yet many people lacking health insurance still find a way to pay for cell phone service.

          • Rob says:

            govenar-
            I think you missed my point. Medicaid eligibility isn’t measured in fractions of people. Also, the average US family isn’t a single-income household living off $9.35/hour. So using averages for the entire US population gives us little or no insight on the 110 people saladdin works with.

            My point was that in order for one of the households that saladdin describes to be ineligible for Medicaid, it would have to be a single-income family consisting of 3 people (no less, no more) with no write-offs.

            And my point regarding cell phones was one of priority, not necessarily one of direct comparison. Even the lowest individual plan by major cell phone carriers costs approximately $50/month after taxes and fees (and significantly more for additional lines). What I didn’t mention was that I was being conservative in my $80/month statement. I found a handful that were in the $60-65 range also. Yet many people lacking health insurance still find a way to pay for cell phone service.

          • govenar says:

            “in order for one of the households that saladdin describes to be ineligible for Medicaid, it would have to be a single-income family consisting of 3 people (no less, no more) with no write-offs” – aren’t 1-person households (no kids) also usually ineligible for Medicaid?

        • NateUVM says:

          “I don’t see why I should be expected to pick up the cost.”

          Because everyone deserves to have access to health care. Because we, as a country, are being brought down by the present expense, and that a little current investment can bring dividends down the line.

          If you don’t think that the wellfare of others doesn’t impact your bottom line, you’re dead wrong. Why do you think your costs are already so high? Part of it is because people are forced to use emergency rooms as primary care facilities. More is due to there being a lack of preventative care and waiting until medical conditions become acute (and subsequently more expensive) before seeking treatment.

          No matter what the solution is, people are going to have to pay more, now. Same with the deficit. Same with anything. You want better conditions in the future, you’re going to have to sacrifice something now. Sort of like saving for retirement… Sacrifices need to be made.

          People tend to be more alike than they want to admit. Sure, there are people who would rather not “contribute a dime”…just be sure not to forget to include yourself as a part of that population.

          Is the Democrat’s proposal the right one? I don’t know. But liberals and conservatives both agree that we need reform, and we need it now. Either way, it is going to require sacrifice to get it done.

          • MoodyBlue says:

            We’ve come kind of far afield from “Factors to consider…Roth IRA”, haven’t we.?

            I’m new here. Is this what normally happens on this board?

          • pmulroy says:

            MoodyBlue,

            This is why I hesitated in replying to NateUVM, as this issue tends to take over discussions. I’ll just end by saying I have a fundamentally different world view than Saladdin and NateUVM and leave it at that.

  11. Jimmy says:

    I am hoping a increment in my income this coming year and i wish to save a part of it for my son’s educational expenditure. Yes TJM AMT factor will prove quite a lot beneficial and crucial.

  12. Great point Jim about diversification. Everybody is under the assumption that taxes will be higher in the future, but there is no guarantee on that. I’m not really certain, but is there any guarantee that the government can’t just tax income from a Roth-IRA down the road if the government gets in a bind?

  13. sks says:

    One significant caveat, not all states have matched federal tax law for Roth IRA conversions. Wisconsin is one example and I believe there are a few more. In these states, you may not average the tax impact over two years and may incur penalties for a conventional IRA withdrawal, reducing the potential benefits associated with a conversion. This reality is rarely mentioned in articles about Roth IRA conversion.

    • Jim says:

      That is an excellent point that I didn’t even know, that could lead to some discrepancies in your return if you split it across 2011 and 2012 for federal but had to take it all in 2010 because of state taxes. Good catch…

  14. Daniel says:

    Does anybody know when the deadline is to convert your Traditional IRA to a Roth IRA for 2009 taxes?

    I did a pension rollover to IRA in November and I am would like to convert to Roth and appear as part of 2009 taxes.

  15. Chris says:

    Does anyone know more about the phasing out of student loan interest at $110k?

    • David says:

      All my numbers are for joint filing (because that’s what we are). For 2009, the phaseout begins at 120k AGI and ends at 150k AGI. So if you make less than 120k, you can deduct 100% of your student loan interest paid in 2009. If you make more than 150k, you get nada. Make between 120k and 150k? Just take your AGI and subtract 120k, then divide by 30k. That is your DISALLOWED percentage. Good luck…

    • David says:

      Oh yeah, the max total deduction is $2500.

  16. reinkefj says:

    @nateuvm With all due respect, the progressives want control. It’s not about health, health care, or health insurance. Instead of a rush to “do” “everything” at once, how about we try one idea per year. And “triangulate” in on the best answer. Start with something that EVERYONE agrees is wrong (i.e., tying health insurance to employment). Let’s fix that by making premiums deductible to real people. Force corporation to spin it the cost to real people. If the company pays your insurance, then they can deduct it. If you pay it, you can deduct it. Level the playing field. Wait and see it that is “enough”.

    • NateUVM says:

      With all due respect, attempting to get something done since 1948 does not, in my opinion, indicate a “rush to do everthing all at once.” That’s how long we’ve been trying to fix health care.

      The idea that this is being rammed through without due consideration is GOP spin.

      You say “progressives want control.” My first question would be, “what control would this give them?” Second, though, it’s not as if Conservatives don’t want reform, too. They just don’t want it in a form where doctors can still be sued for malpractice. They don’t want insurance companies to have to face real competition.

      I agree with you, let’s fix this thing. But blaming one party(or philosophy) or questioning their motives, etc…is NOT the way to get it done. Good ideas(from either party) with bad motives are STILL good ideas.

  17. @Jim – these are some great points, especially in regard to higher tax brackets. The 2010 Roth IRA conversion in particular allows people to defer 50% of their tax bill until 2011 and 50% until 2012 (this is for 2010 only). But what some people might not consider is that their income might rise for one or both of those years.

    AND, the likely expiration of “the Bush tax cuts” will push tax rates up for everyone starting next year. So, if you’ve got the money to pay the tax, you probably don’t want to defer!

  18. reinkefj says:

    @NateUVM

    It gives them the power of “life and death”. And, don’t think it won’t get used and abuse. “Yes, Comrade NateUVM, you do have free speech, but for speaking out against the war (who knows which war it will be), you’ve been awarded a status of ‘category 12′ for you AND YOUR FAMILY. So, you can ONLY have aspirin and there will be a 7 year wait to see the specialist. If only, you’d have supported the war, you’d be category 21 and entitled to everything.”

    Yes, like the Japanese internment, it CAN happen here.

    I think the striongest argument against “gooferment healthcare” or “health insurance” is that if the gooferment screws you as opposed to the insurance company, where do you go for relief? The gooferment’s courts. Now you can sue. In the future, you may have no recourse.

    SECOND I can’t speak for “conservatives”, (I’m a little L libertarian), but I’d like simple slow progress on specific issues, well understood well thought out. The idea of the equal tax treatment for insurance seems to be one that EVERYONE can agree on. And, goes a long way to unwinding the distortion cause by FDR’s wage and price controls that led to “benefits” in the first place.

    Gooferment creates the problem and then gives us more gooferment with more unintended consequences to solve it.

    Argh!

  19. Tim says:

    taxes are only going up, which gives a really strong argument to converting if you have the funds to pay the extra tax.

  20. Rob says:

    A person should also consider where they plan on living during retirement. If he/she plan intends to live in a state with low or no income taxes and currently live in a state that has significant income taxes, you may be better off staying with your traditional IRA. I believe this also applies to living outside the country. In that case, I believe you can also choose your state of residency and pay income taxes according to that state’s laws.

  21. Soccer9040 says:

    Can you roll right from a 401k into a Roth with this? I only have 401ks and Roths. Just curious.

  22. RogerC says:

    What about the state tax implications? Will the states allow you to split the tax owed to 2011 and 2012? I think some states have laws that will have to be changed to allow that.


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