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2010 Roth Conversion: Good Idea?

This article was written by in Investing. 6 comments.


Over the next couple of weeks, six finalists will be auditioning for the opening of “staff writer” at Consumerism Commentary. Each will be providing two guest articles to share with readers. After the six writers have shared their guest articles, readers will have an opportunity to provide feedback before we select the staff writer.

This article is presented by J.J., a financial adviser and published financial author.

Roth IRA conversion rules are changing next year. Even if you make more than $100,000, you’ll be allowed to convert Traditional IRA money into after-tax Roth money. You can even spread the tax payments out over a few years to make it easier if you convert during 2010.

Does it make sense to do so?

We’ve touched on the 2010 Roth conversion rules before. Let’s dig deeper into why it may or may not make sense to convert.

Why convert?

The 2010 conversion rules may help some taxpayers. In general, the opportunity is more attractive if:

  • You think tax rates are headed higher
  • You’ve been making nondeductible IRA contributions
  • You have a high net worth or you want to leave more for your heirs
  • You want to diversify the tax status of your money, just like you diversify your investments

Higher tax rates

With higher tax rates in the future, you can get your tax payment out of the way now — at a lower rate. What might make tax rates higher in your retirement years? You could have higher earnings, lawmakers could raise tax rates overall, or both.

With all the talk of government bailouts and broken entitlement systems (like Social Security and Medicare) it’s easy to see why rates could go up. The government needs money, but the solution may not be as simple as an income tax rate increase. There are other ways they can drum up cash:

  • Consumption or value added taxes (VAT)
  • Change how much you and your employer pay for Social Security
  • Change limits on retirement plan contributions
  • “Forget” to change certain limits with inflation (IRA and retirement plan contributions, compensation recognized for Social Security and retirement plan calculations, etc)
  • Change the laws and make Roth distributions taxable (or potentially taxable, like Social Security benefits)
  • Other strategies I’m not smart enough to understand

If you’re betting on higher tax rates, make sure you understand how the bet can go wrong.

Nondeductible contributions

If you’ve been making nondeductible contributions, you’ve practically made Roth contributions anyway. In fact, you probably couldn’t deduct the contributions because you make too much money. For you, the conversion option is worth investigating because it would allow you to get the earnings out tax-free – as opposed to just the contributions.

Ideally, you’ve been making nondeductible contributions in recent years, and you have little or no earnings in the account after the recent market decline (sometimes there’s a silver lining). If so, the tax hit may be minimal. However, you should look at all your IRA accounts in aggregate to figure out how much it’ll cost.

Diversify, diversify, diversify

Diversification is another decent reason to consider converting. Most people have all (or a majority) of their retirement savings in Traditional pre-tax accounts. They’ll have to pay income tax as they spend that money. Since we don’t know what tax rates will do, it may make sense to hedge your bets.

If you have a choice of funds (pre-tax and post-tax) in retirement, you can choose whether or not to increase your tax bill in a given year. Suppose you do some consulting work and earn money – it may make sense to take a Roth distribution that year. On the other hand, you can take Traditional distributions when you have little or no taxable income.

Estate planning

If you’re fortunate enough to have an estate planning problem — or just more money than you need — then Roth money can come in handy. By converting, you pay taxes today so your heirs can take tax-free distributions (unless they change the rules and start taxing Roth distributions, of course). You also remove money from your estate when you pay the tax bill.

You’re required to take distributions from Traditional IRAs during your lifetime, starting after you reach age 70.5. The government wants you to generate some tax liability on all that money you’ve been protecting, so they force you to dribble it out over your remaining years. Roth IRAs do not have this requirement, so you can leave more for your heirs.

Proceed with caution

If the idea attracts you, don;t rush into anything. In the coming months, we’ll learn more about the complexities of the 2010 conversion rules, and how the landscape may change (for example, will tax rates increase in 2011 and 2012 — making it less attractive to spread the payments out?). Unless tax rates in your retirement years increase substantially, you probably won’t hit a home run by converting. However, you might come out ahead or just enjoy having more flexibility in retirement.

Remember that if you earn over $100,000, you’re already in a fairly high tax bracket (at today’s rates at least). A conversion won’t be cheap, and you should pay the taxes due from savings available to you outside of your retirement accounts.

Give your eyes a break and listen: a recent Consumerism Commentary podcast has more insight into the 2010 conversion rules.

Will you take advantage of the Roth conversion rules next year? Why or why not?

Published or updated November 15, 2009. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

J.J. is a consultant for employer retirement plans and works with credit unions as a financial adviser. He works with individuals and businesses every day as they make important decisions about their money. View all articles by .

{ 6 comments… read them below or add one }

avatar Financial Samurai

JJ, can you discuss what you would recommend folks in the Top Federal tax brack ($370K+) should do out of curiousity?

The contribution amounts before seemed so pathetically small, but at the same time the 35% bracket seems like it will go to 39.6% next year.

Reply to this comment

avatar J.J.

I hate to be annoying, but the short answer is: it depends.

Longer answer: they should really run some numbers and make guesses about what the future brings. At that income level, it seems like tax rates have to really go up for the conversion to be wildly successful (assuming income tax on distributions is the only thing that matters). However, it always makes sense to do some “what-if” work.

Regarding the small contribution limits, they may be able to sock away a little more with Roth 401(k) contributions. If they make that much, let’s assume they have some influence in the company and can lobby to get the Roth feature added. Self employed individuals can do a Solo 401(k) with the Roth feature.

I’d assume these people have substantial retirement savings and will be in a high tax bracket at retirement no matter what they do. They might decide that converting makes sense even if tax rates don’t go up because it provides diversification and peace of mind (or “insurance” – that they can afford – against income tax rates skyrocketing). Or maybe not.

An estate tax problem is a distinct possibility for those high earners. Converting, taking the hit at a rate that may be lower than estate tax rates (but who really knows what’ll happen with the estate tax?), getting money out of the estate, and helping (presumably wealthy) heirs may make sense. Again, it depends what’s going on with each individual.

Maybe they run a business that has substantial operating losses (or they will soon) – it may be possible to time a conversion with those losses – not just in 2010.

Ultimately, we all have to decide what we think is likely to happen, and what we’re willing to risk. Then we have to do something or nothing, and live with the outcome. For people who make more than 370k, it’s well worth their time to fiddle with the numbers or pay smart people to do it for them.

Regarding tax rates immediately after 2010: they may choose NOT to spread out the payments over the next 2 years, or they might be able to convert and then “un-convert” in early 2011 if things look bad. Of course, anybody thinking of this should work with an accountant to make sure they follow all the rules and do things the easy way.

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avatar vcmcguire

JJ, this is a great post. I’ve been sort of ignoring the furor over the 2010 conversion opportunity because I’m well below the income limits so I’ve been contributing to a Roth for years. But I have a bit of money in a rollover IRA and I’ve been trying to decide whether to move it to my Roth or not. Your post does a great job laying out all the considerations.

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avatar Britt

Under “Proceed With Caution,” you note that a possible rise in tax rates makes it less desirable to spread out tax payments to 2011 and 2012.

Those considering conversion should also take into account that 50% of your Roth distribution is taxed independently in each of those years. So if you get a bump in earnings that puts you in a higher tax bracket, it’s not advantageous to spread out the tax payment.

For instance, say you have a $100,000 taxable distribution, and you’re current tax rate is 25%. You may think this means you owe $25,000, of which you can pay $12,500 in 2011 and $12,500 in 2012.

But, each 50% is taxed at your personal income tax rate in the tax year in which you pay the tax.

So, if you get a bonus or pay raise which puts you in the 35% tax bracket for year 2012, you end up owing $17,500 in that year instead of $12,500.

So as you say… Proceed with caution! Make sure you think everything through before committing to a 2010 Roth IRA conversion.

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avatar Brad

If I convert in 2010 I can choose to put the income on my 2011 and 2012 taxes equally.

What if I want to put income in all 3 years – 2010, 2011, 2012? Can I do that?

If so, would it have to be 33/33/33? Or is the only requirement that the 2011 and 2012 portions be the same, e.g. 30/35/35?

Thanks!

B

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avatar Ryan

I think Britt did a great job of pointing out a scenario in which you might get socked with higher tax brackets than expected.

Anyone looking to convert should really seek the help of a financial professional or be comfortable with the consequences if they do make an error.

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