Generally it makes sense to convert a traditional IRA to a Roth but there are so many variables that need to be considered to know for sure whether or not it is a smart move. So, let’s examine some situations in which it generally makes sense to convert.
Those in their 20, 30s and Sometime 40s
The younger population is likely to benefit far greater from a Roth IRA conversion than the older population. For instance, someone that is 55 years old would have to pay taxes on the conversion and earn a high enough return in four years to cover the cost of the conversion.
Don’t Expect Tax to Fall Much After Retirement
It really doesn’t make sense to convert if you anticipate your tax bracket to significantly decrease after retirement. The reason to convert is for the tax free appreciation over time but if your tax bracket falls from 28% to 10 or 15%, the savings is likely minimal.
Plan to Give IRA to Heirs
If you plan to give your IRA to your heirs, then a conversion makes a lot of sense. There is no minimum withdrawal requirement for a Roth IRA holder like there is with an IRA holder (must withdraw by 70 1/2). Essentially, you could hold the assets in your Roth IRA throughout your lifetime.
Those That Can Pay The Tax Bill
IRA holders that convert to a Roth IRA will have to pay taxes on the appreciation of the IRA since the IRA was funded with pre-tax dollars while a Roth is with after-tax monies. However, the Roth IRA conversion rules allow taxpayers that convert their IRA to a Roth in 2010 to defer their tax liability by reporting half in 2011 and half in 2012. If you haven’t converted yet, then you missed the boat on this benefit.
Won’t Lose Other Tax Benefits
In addition, be mindful that a conversion can cause an increase in your adjusted gross income which may disqualify you from other tax benefits such as the child tax credit and certain education credits.
Parents with Children Going to College
If a parent expects to be older than 59 1/2 when their child goes to college, a Roth IRA may make a lot of sense. At this age, they can withdraw funds tax-free without any penalty AND any tax on the growth of earnings. Essentially, these are the same tax benefits of a 529 plan but with a Roth account, the funds can be used for purposes other than higher education expenses. The 529 plan does not have the same flexibility since you will be penalized if funds are used for anything other than higher education expenses. As a side note, if you are under the age of 59 1/2 you could withdraw Roth IRA funds for higher education expenses without facing a penalty, but you would be taxed on the earnings.
We strongly recommend that you do some scenario analysis comparing what tax bracket you are in now and what you think you might be when you begin taking distributions. Apply those assumptions to a Roth conversion now, versus keeping the funds in a traditional IRA or any other option you are considering.
Tax Questions?
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