In tax planning, the goal typically is to delay the payment of income taxes. Thus, it can be difficult to understand why it might make sense to convert a traditional individual retirement account (IRA) to a Roth IRA, which results in the current payment of income taxes.
Factors that favor converting to a Roth IRA include:
- You can pay the income taxes due from the conversion with funds outside the IRA. By doing so, you are in essence increasing your IRA’s value by the amount of tax paid. Amounts converted must be included in income if taxable when withdrawn (i.e., contributions and earnings in deductible IRAs and earnings in nondeductible IRAs), but are exempt from the 10% early withdrawal penalty.
- You expect your marginal tax rate at withdrawal to be equal to or greater than your current marginal tax rate. When your rates are equal at both times, the financial results from either IRA will be similar. Increasing income tax brackets generally make it advantageous to convert to a Roth IRA.
- You won’t make withdrawals from the Roth IRA for a long time. Estimates indicate that you generally need five to 10 years of tax-free compounding to compensate for the current payment of taxes.
- You don’t expect to take withdrawals from your IRA. Since you aren’t required to withdraw funds from a Roth IRA, even after age 70 1/2, your IRA balance can continue to grow on a tax-free basis.
- You want to leave your IRA balance to heirs. With a Roth IRA, your heirs receive the proceeds free of federal income taxes. Also, if you don’t withdraw funds from the Roth IRA after age 70 1/2, you could potentially leave your heirs with a much larger balance than from the traditional IRA.
Some factors that may indicate you should not convert to a Roth IRA include:
- You have to pay income taxes due from the conversion with IRA funds. The amount withheld for this purpose will be subject to income tax and the 10% penalty if you’re under age 59 1/2.
- You expect your marginal tax rate when funds are withdrawn to be significantly lower than your current marginal tax rate. In this situation, you will typically experience better financial results by leaving the balance in your traditional IRA.
- You will make withdrawals after a short time. Thus, the tax-free compounding of earnings won’t offset the current payment of income taxes.
- Income from the conversion would increase your adjusted gross income (AGI) to a level that increases your marginal tax rate or prevents you from using some tax credits, deductions, or exemptions.
- You expect to withdraw the majority of your IRA funds during retirement. Thus, the estate planning aspects of a Roth IRA are not of interest.
To convert from a traditional IRA to a Roth IRA, AGI for single taxpayers and married taxpayers filing jointly cannot exceed $100,000 in the year of conversion. This limit does not include any income resulting from the conversion. Also, starting in 2005, required minimum distributions from traditional IRAs are no longer included in the $100,000 limit. Amounts that have been rolled over from a qualified pension plan, such as a 401(k) plan, to a traditional IRA can also be converted to a Roth IRA. Once the balance is converted, qualified distributions cannot be made until after the five-tax-year holding period. Distributions before then are subject to the 10% early withdrawal penalty, unless one of the exceptions applies.
You do not have to convert your entire IRA balance. You can convert only a portion, which may help with the payment of income taxes.