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Four Factors to Consider Before Roth IRA Conversion
Posted By Jim On 02/01/2010 @ 12:06 pm In Retirement | 44 Comments
Now 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.
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.
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.
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.
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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 Roth IRA conversion: http://www.bargaineering.com/articles/roth-ira-conversion-rules.html
 tax brackets: http://www.bargaineering.com/articles/federal-income-irs-tax-brackets.html
 Value Added Tax: http://www.bargaineering.com/articles/value-added-tax-vat-explained.html
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