In the Roth IRA, what you see is what you get. With the traditional IRA, you get less than what you see because withdrawals are taxable.
“It’s as if the IRS owns part of your traditional IRA,” explained Kaye Thomas, a tax lawyer and consultant based in Lisle, Ill. The government’s stake in your individual retirement account depends on future tax rates — and the consensus is that tax rates have nowhere to go but up. Mr. Thomas is the proprietor of Fairmark Press Inc. and writes books on taxes and investing.
“The sooner you get Uncle Sam out of the equation, the better,” said Ed Slott, a certified public accountant in Rockville Centre, N.Y.
Nevertheless, clients often don’t want to pay the upfront tax on the amount that’s converted.
That’s where timing comes in. During a client’s working years, a low-cost conversion can be the silver lining in a difficult year — when between jobs, for example.
But the
best time for Roth IRA conversions is after age 59½ and before age 70½, said Joel Isaacson, president of Joel Isaacson & Co. Inc. in New York. In the early years of retirement, the conversion tax can be substantially reduced or even eliminated, he said. Mr. Isaacson is a certified financial planner and certified public accountant.
Roth conversions are currently available only to people with less than $100,000 of annual household income. In 2010, they will become universally available. But even under the existing rule, Roth conversions are an option for more people than you might think, Mr. Isaacson said.
“We see this all the time. People retire with a seven-figure tax-deferred account and no traditional pension, and their taxes drop off a cliff. Their non-retirement money is in municipal bonds, and they still have hefty deductions for property taxes, mortgage interest and charitable contributions,” he said. “They can often convert $60,000 to $70,000 a year to a Roth for seven or eight years without owing any tax on it — and maybe pay an effective 10% to 15% rate on the next $60,000.”
See also: Are Roth conversions after 70½ advisable? 5 factors to consider - Future tax rates and when the money will be needed are among the things advisers should take into account.
Other issues need to be considered in determining whether to convert a Roth IRA to a traditional IRA.
Will a Roth conversion push the client into a higher bracket? If he’s near the top of the 15% tax bracket before the conversion, most of the income from the conversion may be taxed at the 25% rate, said Mr. Thomas. The real cost of conversion includes its impact on the rest of the client’s tax return, he said. To the extent that a conversion boosts adjusted gross income for the year, for example, it may be enough to phase the client out of potential tax deductions or credits, or make his Social Security benefit taxable, Mr. Thomas said.
Does the client have an outside source of cash to pay the tax on the conversion? A conversion makes much less financial sense if the tax must be paid out of the IRA, Mr. Thomas said. He recommends figuring out how much tax the client can handle without dipping into his IRA assets, and then calculating how much of the traditional IRA can be converted for that amount of tax.
How long does the client expect to leave the Roth untouched? In the long run, a Roth IRA’s tax-free earnings should more than cover any upfront tax cost of conversion. But how long will the long run be? The sooner the client must tap the Roth, the less time it has to overcome its initial cost. Roth conversions make the most sense for people who have other assets to live on, and/or plan to leave the Roth IRA untouched for their children or grandchildren, said Mr. Slott.
A conversion is particularly attractive for anyone with a taxable estate, noted Mr. Thomas. The estate tax on a $500,000 IRA is the same whether it’s a traditional IRA or a Roth IRA. But beneficiaries pay income tax on their withdrawals from a traditional IRA. With a Roth IRA, they get to keep the amounts they withdraw.
“What it boils down to is that you’ve reduced the size of your estate — by prepaying the tax on your IRA — without reducing its value,” Mr. Thomas said.
