There has been a lot of talk about the changes to the tax laws that take effect this year surrounding Roth IRA conversions. What’s all the brouhaha the about? Well, the biggie is that the $100,000 income ceiling limit for conversions from traditional IRAs to Roth IRAs is permanently repealed and married individuals who file their taxes separately can convert now, as well. (Notice this change affects only conversion limits, not the previously discussed Roth contribution limitations. Those stay the same.) Therefore, these changes benefit mostly higher income individuals who wouldn’t otherwise be eligible for a Roth.
If you’re thinking about converting, you should definitely discuss it with your financial planner or tax advisor, first, to understand all of the benefits/consequences. Here are some questions from Financial Planning magazine you should consider in preparation for giving them a call.
Do you have funds available to pay the taxes on the conversion? The applicable taxes of a conversion must either be paid through the proceeds from the distribution itself (which may have associated penalty tax consequences if you are under age 59 ½) or through some other source. While you can take over 2 years to pay the taxable amount, the money still has to come from somewhere. A special IRS provision allows you to claim 50% of the conversion amount as income in 2011 and the remaining 50% in 2012, but at your prevailing tax rates in those years. Therefore, you should think about how long it will take for you to earn back the cost of the conversion.
How long after converting do you expect to keep your funds in the Roth IRA? IRAs are longer-term investments and the major benefit of the Roth is the tax-free growth of the funds. Obviously, the longer the funds grow, the greater the benefit, so you need to determine when you will need to take distributions from your IRA accounts to fund your retirement or other long-term goals.
Do you expect your tax rate to be higher or lower in retirement? If you believe you will be in a lower tax bracket in retirement, paying the tax for the Roth conversion at today’s higher rate may cost more than the tax due from traditional IRA distributions in retirement. On the other hand, if you think your tax rate will be higher in retirement, paying for the conversion now may be less costly than the taxes due from traditional IRA distributions later on. While there are online calculators for this type of comparison, given all of the potential variables, you should talk with a financial professional familiar with your individual circumstances for a more reliable comparison.
Lastly, do you need your IRA accounts to fund your retirement, or do to plan on giving those IRA assets to your heirs? One of the possible benefits of not having to make those required minimum distributions is that you can use the Roth as an estate planning vehicle to leave funds to your heirs through the beneficiary provision. However, this should also be discussed with a financial professional and considered along with other estate planning options available to you.
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