Donald Paris, CPA
I have no idea how many times I am asked the question, "Should I convert my Traditional IRA or 401(k) to a Roth IRA?". Plus, so much has been written on this subject to make the issue very confusing. The calls come in from clients, investment advisors, lawyers, and other folks who advise clients. Let’s start by understanding the basics. In 2010 you can convert your Traditional IRA and 401(k) to a Roth IRA, and not have to worry about any income based restrictions (last year, folks with an Adjusted Gross Income (AGI) over $100,000 were not allowed to make this conversion). The only catch is that, when you convert your Traditional or 401(k) to a Roth IRA, you pay tax at ordinary income tax rates. On the contrary, with a Traditional IRA or 401(k) you pay the tax when you withdraw the funds, presumably sometime in the distant future.
So, you ask yourself, "Why would I want to pay taxes on something now, when I could pay the taxes later?" Because, if you pay taxes later, you also pay tax on the accumulated gains and growth in the account. But, before you rush out and tell your investment advisor that you want to do this, you should understand a Roth conversion is not for everyone.
One client of mine is a lawyer and currently 60 years old. She is currently in the 32% effective federal tax bracket, and plans to retire at 70. If she retires and her only source of income is her investments, i.e. she has no more income from being a lawyer, it is likely that this rollover is not a good thing for her. That is because, at retirement, I anticipate her effective federal tax rate to be as low as 22%. Even with growth of the retirement account, conversion right now would cost her money. Thus, she should leave the money in the 401(k), and take it out as taxable income when she retires. Instead of retiring at 70, if she retired at 75, the conversion will still cost her money. But, what if she "semi" retired at 70, keeping some of her clients, and some active income? Now the conversion makes sense because her tax rate is higher than the expected 22% when she "retires", and thus, paying the tax now on the conversion puts money into her pocket.
So, what options do you have to pay the tax? First, there is a huge benefit: if you convert your Traditional IRA or 401(k) to a Roth IRA in 2010, you can split this income in half and report it/pay tax on it equally between 2011 and 2012. Yup, convert this year and pay the tax later. Also, you should pay the tax from "taxable investments" instead of from the IRA. Paying the tax from your taxable accounts allows you to grow your Roth tax-free, from a higher base. If you pay the conversion tax from your taxable investments, you lower your tax now, and lower your tax later, since your Roth grows tax-free.
Do you have Net Operating Losses (NOL) or charitable contributions that you are just holding onto and carrying from year to year? Then seriously consider converting in 2010. The NOL or charitable contributions offset the conversion income, and who knows? You may significantly reduce any tax on the conversion.
You should also know that taxability of Social Security income is dependent on all your other income. The more you have of other income, the more taxable your Social Security is. So, converting to Roth will keep your taxable income lower in Social Security years.
Income tax rates are expected to go up to a highest marginal rate of 39.6%. Add your state rate to this and you could be paying close to 50% in tax, if you are in the top brackets. So, you have to ask yourself, if the tax rates go up in 2011, and I am in the top bracket, do I really want to defer the tax? Maybe not. Maybe you want to pay all the tax in 2010, when you convert, and save the almost 5% additional tax that we expect.
Converting to a Roth is very complicated and requires serious tax planning between your tax advisor and your financial advisor. There definitely is not one answer. This type of tax planning allows you to keep the tax law in mind, while making life decisions.