Convert your IRA to a Roth IRA
September 01, 2009

Clients and friends, the Roth IRA may be one of the best deals in retirement planning.
You need to take note of this and decide if you should convert your IRA to a Roth IRA.

You can analyze the all the plusses and minuses, but you will generally find that most people are better off in the Roth IRA for several reasons. Here’s why.

The Roth account is more valuable

In short, when you retire, a Roth IRA is effectively bigger. The reason is two-fold.

First, it holds after-tax dollars. So your contribution to this account can prove to be equivalent to, or greater than, a contribution to a traditional IRA that is taxed upon withdrawal. For example, if you are in a 25 percent tax bracket, you were able to contribute up to $5000 to an IRA in 2008. By using a Roth IRA, the $5000 contribution is post-tax and equivalent to a pretax amount of $6667, which is, in effect, larger than the contribution you can make to a traditional IRA.

Second, since the distributions from a traditional IRA account are taxable, while those from a Roth IRA are not, the difference can be surprisingly large. For instance, if you retire in the 25% (22% Federal, 3% State) tax bracket, you will have to take out $1,333.33 in order to have $1,000 left in spending power. What if you are in the 32% tax bracket with a 3% IL state tax? You’ll need to take out $1,538.50 just to get $1,000 in spending. See the chart below for other tax rates.

Amount Equivalent to $1000 in a Roth Account
Tax Bracket Amount
10% $1111.11
15% $1176.50
25% $1333.33
28% $1388.90
33% $1492.50
35% $1538.50

The Roth IRA is more flexible

First, the minimum distribution rules don't apply. If you're able to live on other resources after retirement, unlike a IRA, you don't have to draw on your Roth IRA at age 70½. That means your earnings continue to grow tax-free. You also have the ability to take certain early distributions without paying a penalty. So holding a Roth IRA allows you to keep your money growing tax deferred longer, and allows you greater leeway to make withdrawals.

Starting in 2010, the current income limitation (of $100,000) that prohibits you from converting an IRA or workplace retirement plan to a Roth ends. If you do convert in 2010 you will have to pay taxes on contributions and earnings in that account before you convert it, but in most cases it will be well worth it because virtually all of the income growth and withdrawals are tax-free with a Roth.

Even better, assuming your tax rate does not go up in the following years, you can report all the amount converted on your 2010 tax return or spread it over the years 2011 and 2012. For the maximum benefit, you will want to pay the tax on this conversion with dollars from a source other than your IRA (especially if you are under 59 ½, since you will also incur the 10% early withdrawal penalty).

The Roth IRA also presents strategic options

If you want to maximize the amount you convert to a Roth IRA, and you are over the income limits of contributing to a Roth this year, then open up an regular IRA before the end of the year ($5,000 if you are under age 50 and $6,000 in 2009 for ages 50+), then next year convert it to a Roth IRA. And keep in mind that you can follow this strategy year after year.

Should you do it?

Here is a short list of the most salient advantages of converting:

*With tax rates going up, you may be in a higher tax bracket when you retire. Paying taxes now may mean much lower taxes down the road.

*Withdrawals are tax free as long as you at least 59 ½ years old and wait five years before withdrawing funds.

*There are no required distributions as there is with a traditional IRA, which requires you to start taking distributions by age 70 ½. So a Roth IRA can continue to compound its growth tax free.

*Your heirs do not owe income tax on the withdrawals, though beneficiaries to have to take distributions across their life expectancies and Roth assets are still included in an estate’s value. This may make a Roth IRA’s a good alternative to life insurance.

Also, there are some issues to keep in mind.

In order for the Roth conversion to work for you, you are making the assumption that tax rates are going to rise. However, between now and your retirement there may be many changes.

Opponents say, “Why pay tax now if you don't have to do so? By paying taxes now, your base to grow your IRA funds is reduced. Proponents say, “You may end up paying income tax on twice as much money, or five times as much, if you don't convert. Why pay tax on income that can be exempt?”

Investment choices always involve uncertainty, and in this case one of the uncertainties is future.
Stretching you tax liability on the Roth conversion to 1010 and 2011 is attractive, but what happens if Congress passes a tax increase prior to then? Careful analysis is needed, especially to make sure that the amount that you convert from your IRA that is added to your income will not push you into the next tax bracket.

In conclusion, what you do depends on your personal situation, from the years you have until retirement to the assumptions you are making about the future. What will your tax bracket be then? What earnings can you anticipate in the interim?

Need help in deciding whether to convert? I would be happy to review with you your situation and explain the rules.

Susan Templeton

September 2009