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JUST BECAUSE YOU qualify to open a Roth IRA doesn't mean you can convert your plain vanilla IRA into a Roth. Unfortunately, the income limits for conversion are lower than they are for opening new accounts -- $100,000 adjusted gross income for joint filers and singles. The other problem is that you have to pay taxes on the conversion. That can entail a big cash outlay -- cash you may or may not have at the moment.
But if you qualify -- and can afford the taxes -- you probably should convert for all the reasons we mentioned in Which IRA Is Right for You?. The worksheet below will walk you through the raw numbers. And the discussion will explain the other issues you need to consider.
Do You Have the Cash?
This is the biggest hurdle to conversion. The problem: When you move your regular IRA to a Roth, you will have to pay taxes on any pretax contributions. And you have to pay during this tax year.
Technically, you could use some of the IRA money itself to pay the tax, but that's a bad idea. If you do, you will owe a 10% withdrawal penalty on that amount. Plus, you lose the opportunity for tax-free compounding of that principal.
To minimize your tax hit, you could, of course, convert just part of your account. But you can't avoid the tax by only rolling over your after-tax contributions. Each dollar you roll over from your IRA is considered a "blended" dollar and taxed to the extent the entire account would be.
"If you have the money or can get it, you should try to convert, because you would eventually have to pay that tax anyway," advises Steven Corrick, a tax partner at Arthur Andersen in Washington, D.C. "In exchange for that, you get tax-free withdrawals from the accumulated earnings in that account."
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Will the Rollover Disqualify You for Important Tax Benefits?
The conversion income could push you into a higher tax bracket and disqualify you from other tax benefits such as tuition tax credits.
How Much Time Do You Have Until Retirement?
Generally, the older you are, the less sense it makes to convert a traditional IRA to a Roth. You'll have less time to make up for what you lost in taxes on the conversion.
Do You Plan to Leave All of Your IRA to Your Heirs?
One case in which it makes sense for an older, traditional-IRA holder to transfer funds to a Roth IRA is when he or she is planning to leave the money to heirs. Why? Two reasons: First, unlike traditional IRAs, Roths require no minimum distributions during the life of the IRA owner or, upon his or her death, the life of his or her spouse. With a tax-deductible IRA, you must begin making withdrawals from that account at age 70 1/2, losing out on the chance for that money to continue compounding. That can mean a lot less money for your heirs.
Secondly, conversion to a Roth will reduce your taxable estate by the amount of tax you pay. This reduces estate taxes for your heirs.
Will Your Income Tax Bracket Drop After Retirement?
The clearest case in which converting from a tax-deductible IRA to a Roth IRA does not make sense is when you expect to drop into a lower income tax bracket after you retire. Why? You will have to pay income tax on the conversion at your current high rate. Instead, let the money compound in your old IRA and pay taxes at your lower rate in retirement.
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Roth Scenarios
| Conversion Scenario |
Traditional IRA or Roth IRA Starting Balance |
Total After-Tax Income During Distribution Period With Conversion to Roth IRA |
Total After-Tax Income During Distribution Period With Traditional IRA (Including Side Account) |
After-tax Income During Retirement:
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| Advantage (Disadvantage) of converting to Roth IRA
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| 45-Year -Old. 27% Tax Bracket Pre-Retirement and During Retirement |
$50,000 |
$438,986 |
$388,423 |
13.0% |
| 45-Year -Old. 27% Tax Bracket Pre-Retirement and 15% Tax Bracket During Retirement |
$50,000 |
$438,986 |
$445,973 |
-1.6% |
Source: T. Rowe Price.
- Assumes taxes paid at conversion are paid from a side account. If the investor does not convert, money in the side account will grow at an after-tax growth rate. Distributions from the side account will be made over the 20 year retirement period, increasing 3% annually to maintain purchasing power.
- Assumes the investor's AGI is less than $100,000, investor makes no additional IRA contributions, and has an 8% pre-tax annual rate of return before retirement, and a 7% pre-tax annual rate of return during retirement.
- Assumes investor retires at age 65 and takes annual distributions over a 20 year period. The account will be fully depleted after the 20-year period. Distributions are made at the start of the year, and increase 3% annually to maintain purchasing power. Minimum required distributions have been taken into consideration for this analysis.
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