Understanding Roth IRA Conversions
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The opportunity to convert an existing regular IRA to a Roth IRA may be the single biggest upside to the stock market’s extended slide. The younger you are and the more aggressive your investment strategy, the more likely it is that a conversion to a Roth IRA will make sense for you.
You may already be aware of the key difference between a regular IRA and a Roth IRA. At a very high level, a regular IRA provides for tax-deferred growth whereas a Roth IRA gives you tax-free growth. All else equal, we’d all prefer tax-free growth, of course. Here’s everything you need to know about Roth Conversions
Contributions to a Roth IRA are limited and are not deductible
Trouble is, income limitations prevent everyone from being eligible to contribute to a Roth IRA. During 2009, if you’re single and make more than $120,000 ($176,000 combined with your spouse, if you’re married), you can’t contribute a dollar to a Roth IRA. Furthermore, those who can make a Roth IRA contribution can’t deduct it – that’s your key upfront sacrifice for the many future years of tax-free growth.
A Roth Conversion allows everyone access to a Roth IRA
Let’s first define what a Roth conversion is: the transformation of your retirement account from tax-deferred to tax-free status. You effectively move money from an existing regular IRA or former employer’s 401k account into your Roth IRA. The cost to do this conversion is the payment of regular income tax on virtually the entire amount you convert. (You’ll pay tax on 100% of the converted amount unless you previously made non-deductible contributions).
Roth Conversion restrictions are going away
Through the end of 2009, conversions are only available to those people who earn less than $100,000 and have filing statuses other than married, filing separately. However, both of those restrictions are eliminated at the end of the year. As a result, anyone who wishes to contribute to a Roth IRA but whose income level is too high can make a 2009 contribution to his/her regular IRA and simply convert part of their account in 2010.
Why converting your Roth IRA could make sense today
If you’re confident your 2009 adjusted gross income will be less than $100,000, you don’t have to wait until 2010 to convert. Furthermore, you can take advantage of market downturn, as I referenced earlier. Here’s a simple example:
Say you invest in stock and you accumulated 300 shares of Johnson & Johnson stock (JNJ) over the years. If you converted your shares during April of 2008, when JNJ was trading at about $67 per share, you’d have converted $20,100 of stock. Assuming you were in the 25% tax bracket, you would have owed about $5,000 in taxes on the conversion.
In April 2009, JNJ was trading at about $51 per share. If you converted the stock then, you would have converting $15,300. If you were in the same 25% tax bracket, you’d owe just over $3,800 in tax, not $5,000, for a permanent tax savings of $1,200. In either conversion, you retain ownership in the long-term potential price appreciate of JNJ, yet in the latter case you’ve successfully timed the market from a tax perspective.
It’s certainly possible that stock prices could go lower from here and that a further delayed conversion could be even more lucrative from a tax perspective. Nonetheless, a conversion could make more sense for you today than at any time previously.
Take advantage of your youth
The big upside of voluntarily paying taxes (since you don’t have to convert), is the tax-free appreciation of your converted investments. The longer the amount of time you have until you plan on taking your money out (ideally retirement), the greater the odds that a Roth IRA conversion will make sense.
In addition, the better your investment performance between now and retirement, the greater the upside of converting to a Roth IRA. Still, it makes sense to run the numbers. Importantly, it seldom makes sense to convert to a Roth IRA if you don’t have the money available to pay the tax on conversion. Using money from your IRA to pay the tax almost never makes financial sense.
Keep in mind that it’s not an all-or-nothing proposition. If you want to convert your retirement account but just don’t have the funds set aside to pay all the taxes, consider converting some of your account. You can always do some more next year.
Michael B. Rubin is the author of Beyond Paycheck to Paycheck and the blog of the same name. He is the President of Total Candor, a financial planning education company.
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12 Comments so far
leave a commentThis is wrong.
Absent a theory on changing income tax rates, a Roth has no advantage over a traditional IRA.
Converting is great, if you can afford it, but if you can’t, you can always change your future IRA contributions to be ROTH. Depending on who manages your IRA, there may be a small fee for making this change, but you can have both a regular IRA and a ROTH IRA.
Frank’s right. The commutative property of multiplication tells us that if we expect the same tax rate now as during retirement, there’s precisely zero benefit of a Roth over a traditional IRA.
It may also be helpful to note that while eligibility is changing, contribution limits are not. Thus it is important to consider your ongoing retirement contribution strategy as you may favor a partial conversion to a Roth and leave your traditional IRA in place for future contributions.
Don’t you just love a great debate? Thanks to Michael B. Rubin for writing this as many people can benefit from reading it. Also, enjoyed reading the other comments and points of view. I’ll be sure to share many articles from Mint with my members at http://www.millionairemoms.com.
Appreciate it!
Joyce Bone
@ Frank and Mike,
You guys are assuming you had no return on the funds in the investment account. The beauty of the Roth is that it grows tax free and you can take it out tax free. Suppose you started with one investment at $10,000 and, in an extreme example, your one investment returns $1,000,000 by the time you retire. If you did not convert, you would have to pay $250,000 in taxes (assuming 25% tax rate on gains/dividends/income etc) versus $2,500 in taxes when you convert it when the account balance is $10,000.
cheers.
@Frank & Mike,
You are also missing the other hidden benefit of the Roth IRA, higher effective contribution limits. Standard IRA and Roth IRA both have the same contribution cap on is in pretax dollars and the other is in post tax dollars. Say you save $400 a year using a standard IRA in tax benefits. Even if you are careful and invest this money in a taxable account, its growth will not be tax free, unlike the $400 effective extra you have in the Roth IRA.
So if you can max out your IRA, maxing out a Roth IRA is always the better choice.
@ibar In your example the results would be the same. When you pay the $2,500 in taxes upfront you forgo the opportunity to earn interest on this, which in your example, would make this amount equal to $250,000 or the same amount you would pay in taxes at the end. So, based on this the only advantage to a Roth IRA is if you plan for your tax bracket to change between the time when you are converting/contributing to the time when you plan to use the money in retirement.
“a Roth has no advantage over a traditional IRA.”
You are definitely wrong, Roth IRA have multiple advantages to traditional IRAs…
“a Roth has no advantage over a traditional IRA.”
Agreed, Frank is making too many assumptions here. This may be true for his personal situation, but it isn’t true for everyone.
The basics of this change is that it takes away the Conversion Limit. If one is already inhibited by the Conversion Limit and the Roth Income Limit, then they are probably making non-deductable contributions to their Traditional IRA due to to the Deductable Limit. Meaning, they have already paid tax on the money deposited. If this is the case, then they would just be paying tax on any Capital Gains at time of conversion, not the whole account balance.
Now, add the “market’s extended slide” mentioned in the first sentance of the article into this scenario. Even with the recent months’ recovery, some will still be looking at a negative or small Capital Gains compared to what they actually deposited into the Traditional IRA. Convert this IRA scenario over to a Roth and the owner is paying little to no tax, and all future gains are tax free.
Obviously, not everyone will benefit from this, but many will.
The one thing this article doesn’t touch on is the complicated tax scenary if one has both non-deductable and deductable Traditional and Rollover IRAs. As I understand from a finacial advisor, if one has mixed non-Roth IRAs and converts only a partial amount, it will be taxed based on the non-deductable and deductable ratio of all available accounts, not just the account converted from. This will require detailed tracking for future conversions. So, if you don’t have a simple and straight forward situation, please investigate thoroughly before converting.
Other advantages or a Roth:
1) No RMDs are required for a Roth
2) Tax free withdraws in retirement do not affect taxation of social security
3) Withdraws are tax free no matter how large unlike withdraws from an IRA that are affected by our progressive tax rates. For example, depending on other income a person has for the year, a lump sum 50,000 withdraw is taxed at a higher effective rate than a 5,000 withdraw.
So the argument that there is no advantage only holds true if from start to lump sum withdraw, assuming the lump sum withdraw (on Trad IRA) will be taxed at the same rate as was fogone on the Roth contrib.
Don’t forget the time value of money. Roth allows taxable income to grow tax free, while traditional IRAs defers tax on income, which becomes taxable when withdrawn. In a traditional IRA the amount of the avoided tax can grow tax deferred