April 2006
Volume 2, Number 3
Table of Contents

The Benefits of Roth IRA Conversions

By Keith Martinet, CPA, CVA

One of the more interesting retirement planning choices these days is whether to transfer existing IRA balances (including money that originally came from a 401(k) or profit sharing plan) into a Roth IRA. The transfer causes the IRA funds to be taxed as if they were withdrawn. However, after the Roth IRA has been open for at least five years, all distributions are tax-free if the money is used for a first-time home purchase (up to $10,000) or the withdrawal occurs after you reach age 59 1/2, die, or become disabled. Another major benefit of a Roth IRA is that, unlike a traditional IRA, there is no requirement to begin taking minimum distributions at age 70 1/2. Thus, if you do not need the money, funds in a Roth IRA can potentially continue compounding tax-free much longer than they could in a traditional IRA.

To be eligible to convert (or roll over) your current IRA's to a Roth IRA, your modified adjusted gross income for the year of the conversion can be no more than $100,000, and married individuals have to file a joint return. The same $100,000 limit applies to single and married taxpayers. The opportunity to convert is based solely on meeting the $100,000 limit in the year of conversion.

Assuming your income during conversion year will be no more than $100,000 (or that you can find a way to get it there by moving income and deductions around), the real issue becomes whether it makes sense to convert some or all of your IRA's to Roth IRAs. Unfortunately, there is not a simple answer. The correct conclusion depends on factors such as how long you will likely leave the funds in the Roth IRA, what your tax rate is now and what you estimate it will be when withdrawals are taken, and whether you have to use funds from the IRA to pay the tax due at conversion. Generally, you will see a significant benefit from transferring funds to a Roth IRA when:

(1) You (or your beneficiaries) do not expect to make withdrawals from the IRA for at least 10 to 20 years;

(2) Your (or your beneficiaries') tax rate on future distributions at least equals the rate in effect when the traditional IRA is converted; and

(3) You can afford to pay the tax due on the conversion with funds from outside the IRA.

In fact, if you do not have outside funds to pay the tax at conversion, that alone can make a conversion to a Roth IRA a bad move. If you withdraw the funds to pay the tax from your regular IRA before conversion, the withdrawal is subject to regular income tax and the 10% early withdrawal penalty if you are under age 59 1/2.

In addition to the direct impact a conversion has on your taxable income, there may also be an indirect effect. For example, many tax benefits are not available if your income is over a certain level. Thus, in the years(s) in which your income increases because of a Roth IRA conversion, you could miss out on such benefits as child or education credits or deduction for interest expense on a loan for higher education expenses. Other items that could be adversely impacted by increased taxable income include the $25,000 rental exception to the passive loss rules, the personal exemption and general itemized deduction phase-outs, the medical and miscellaneous deductions, and the $4,000 regular IRA deduction for individuals covered by a pension plan. If you have significant assets, you should also consider the impact of estate taxes.

 

Keith Martinet , CPA, CVA, practices in Willoughby, Ohio.

 

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