Two years ago, Congress provided a way for individuals who’s AGIs exceeded the income limits for eligibility to use Roth IRAs. Starting in 2012, there is no income criteria for converting from a traditional IRA to Roth IRA. But now the question is: Should you convert? Here are some factors to consider:
The advantage of a Roth IRA. There are several reasons to prefer a Roth over a traditional IRA. First, when you make withdrawals in retirement, you won’t have to pay income taxes on the amounts withdrawn from a Roth IRA, which means your assets may last longer. Second, unlike traditional IRAs, which require you to make minimum annual withdrawals when you reach age 70 ½, you are not required to take withdrawals from a Roth IRA. Third, if you leave your Roth IRA to your beneficiaries, they aren’t required to pay taxes on withdrawals, even if they haven’t reached retirement age (although estate taxes may apply upon inheritance).
How much do you have in convertible assets? Tally up any assets you may still have in a prior employer’s traditional 401(k) plus any personal or rollover IRAs. You can convert any portion of those funds you want by consolidating them into a single rollover IRA and then making the conversion. If you participate in a 401(k) plan with your present employer, you can convert those assets, too, but only if your plan allows in-service rollovers (many plans don’t).
You are required to pay income taxes on the converted balance. Remember those income taxes you avoided when you contributed to traditional accounts? Once you convert them to Roth assets, you must pay associated income taxes. Amounts converted must be included in income if taxable when withdrawn (i.e., contributions and earnings in deductible IRAs and earnings in nondeductible IRAs). And remember: if you’re under age 59 ½ , taking the cash out of a retirement account to pay the income taxes could trigger the 10% income tax penalty for preretirement withdrawals, in additions to incurring yet more income tax liability. It is better to pay the income taxes with funds outside the IRA. By doing so, you are in essence making an additional contribution to the IRA in the amount of the tax paid.
How many years until retirement? Is it worth it to cash out stocks, bonds, or other assets to pay the conversion tax bill? If you have only a few years until retirement, the conversion may not be worth the expense. While every individual’s situation is different, a good rule of thumb is that you’ll need five or more years before you retire to make the conversion pay off.
What will be your rate of return? How the markets perform and how you invest will affect the return your new Roth IRA achieves. The lower the rate of return, the longer it will take to replace the money spent on conversion taxes.
The conversion may render you ineligible for certain other tax benefits. For tax purposes, you have to declare the amount you convert as income in the year you convert. This might push you into a higher tax bracket and disqualify you for such things as the child tax credit or credits for higher education expenses.
What’s your current income tax rate and what will it be when you retire? If you’re current tax rate is higher than you expect it to be in retirement, it may not make sense to convert. That’s because the conversion tax bill will be higher than your income tax liability when you make retirement withdrawals. In this case, if may be better to allow all of your assets to continue to grow tax free and pay the smaller income tax bill later as you withdraw the money. The flip side of this is that if you expect your income tax rate to be higher, it may well pay to convert sooner rather than later. Of course, this issue is difficult, because Congress has changed income tax rates dozens of times, and no one really knows what they’ll be 10 to 20 years from now.
After considering all of these factors, you can decide whether converting makes sense for your situation. Keep in mind that you do not have to convert your entire IRA balance at one time. You can convert over a number of years or only convert a portion of your IRA balance. However, be aware that if you have both deductible and nondeductible IRA balances, you cannot just convert the nondeductible balances to reduce your tax liability. You have to assume a prorated portion of both the deductible and nondeductible IRA funds are being converted.
Know When to Recharacterize
If you convert and your investments then decline, you end up paying taxes on more than the current market value. However, you can then recharacterize your conversion. For conversions make in 2012, you can recharacterize until October 15, 2013, meaning you can convert back o your original IRA. After the recharacterization, it is as if you did not convert, so you owe no taxes. You can then reconvert at the later of 30 days after the recharacterization or the beginning of the tax year following the first conversion.
You can recharaterize a portion of the conversion. However, if you have several investments in the IRA, you can’t simply choose to recharacterize the ones with the largest losses. In that situation, a prorated portion of all the investments in the account will be considered in the recharacterization. You can bypass this rule by setting up separate Roth IRA accounts for each investment. Then, if one declines substantially, you can recharacterize that account, leaving the other accounts intact.
Roth IRA Contributions
With no income limits on converting to a Roth IRA, this essentially removes the income limits converting to Roth IRA; this essentially removes the income limitations for contributions to a Roth IRA. In 2012, Roth IRA contributions can be made by single taxpayers with adjusted gross incomes (AGIs) less than $110,000 (contributions are phased out with AGIs between $110,000 and $125,000) and by married couples filing jointly with AGIs less than $173,00 ( contributions are phased out with AGIs between $173,00 and $183,000). It doesn’t matter whether you participate in a company-sponsored pension plan. Individuals with AGIs over the limits can make contributions to a nondeductible traditional IRA and then immediately convert the balance to a Roth IRA. However, keep in mind that if you have other deductible IRA balances, you will have to assume a prorated portion of both the deductible and non deductible IRA funds are being converted.
As you can see, there are no easy answers to whether you should convert to a Roth IRA. Please call if you’d like to discuss this in more detail.
Copyright © Integrated Concepts 2012. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.