This may be the first year you qualify for a Roth IRA conversion. But should you make the switch, and, if so, how much of your traditional IRA assets should you earmark for a Roth? Of the many factors affecting your decision, the tax aspects are among the most critical.
Until January 1, you could move money from a traditional IRA to a Roth only in a year in which your modified adjusted gross income didn’t exceed $100,000. Now, that barrier’s gone, and though you’ll owe income tax on most assets you transfer to a Roth, if you convert in 2010, you can spread out the income (and resulting tax liability) over the following two years.
 Once five years have passed, withdrawals you make after age 59½ are completely tax-free. And with a Roth IRA, you never have to take money from the account; for traditional IRAs, mandatory distributions must begin after age 70½. If you don’t need the Roth’s tax-free income, you can pass it along to your heirs.
Eventually, someone must pay income tax on the money in traditional IRAs (except for any portion that comes from nondeductible contributions). You can pay the tax bill now, if you convert your accounts to a Roth IRA. Or it can be paid later, when you or your heirs must empty the accounts. A large part of your decision involves gauging which is preferable financially.
That’s especially hard now, because high-income taxpayers, in particular, could soon pay more in taxes. Federal rates are scheduled to revert to higher levels in 2011, and even greater levies could hit those in top brackets. So while you might normally expect a lower tax bracket during retirement—thus reducing the value of tax-free Roth income—that may not happen. State taxes, too, have an impact, and you need to consider where you’ll get the cash for tax payments. If you tap IRA assets, there will be less money to continue to grow in your tax-sheltered account.
The Roth IRA Conversion Optimizer, a tool used by wealth management professionals, can calculate the impact of different conversion scenarios. Suppose that you’re age 55, your spouse is 50, and you earn $250,000 a year. There’s $500,000 in your IRA. Based on an annual 4% rate of return and a future 28% federal income tax rate, your “optimal net benefit” will be $996,000 if you transfer 100% of your assets, don’t use any of these funds to pay the tax, and make no withdrawals during your lifetime expectancy of 29 years. Note: The "net benefit" doesn't reflect the opportunity cost of using the funds that are paying taxes for other investment purposes.
But what if your future tax rate jumps to 50%? Assuming that nothing else changes, your optimal net benefit skyrockets to $2.12 million over the same 29 years. Even if you factor in a 10% state tax in the year of the conversion, your net benefit will be $1.81 million.
If you’re considering a Roth conversion, we can help you with an in-depth analysis that takes into account all of the tax ramifications. Please call to set up an appointment. |