In the Brothers Grimm telling from the early 19th century, a strange little man named Rumpelstiltskin could spin straw into gold. But you have the 21st-century opportunity to do something very similar, and it’s no fairy tale. You can transform fully taxable retirement income into completely tax-free cash.
This is the first year ever that higher-income taxpayers -- the people most likely to be able to afford to convert a traditional IRA to a Roth -- are allowed to do so. If you take the plunge, all future earnings and all withdrawals in retirement will be tax-free. If you stick with the old-fashioned IRA, the tax picture in retirement is grim indeed: Every dime you withdraw will be taxed in your top tax bracket.
With such a powerful payoff at hand, it’s no surprise that the cost to convert is high. You must pay income tax on all the as-yet-untaxed money you move to a Roth. For most investors, that means paying tax on every dollar converted. (Folks who have made nondeductible contributions to their IRAs can convert those amounts tax-free.)
Congress is earnestly promoting conversions this year. The lawmakers’ motives are not at all altruistic -- after all, conversion lets the IRS collect taxes sooner rather than later on amounts now tucked inside traditional IRAs and outside the IRS’s reach. In addition to abolishing the restriction that used to prohibit conversions by those who have incomes over $100,000, investors who convert this year get to choose either to pay the tax with their 2010 tax returns next spring or to put off paying the piper by splitting the tax bill between their 2011 and 2012 returns.
But just how much will it cost you to convert an IRA? That depends on several factors: how much you convert, how much other taxable income you have, and your top marginal tax rate. Further clouding the issue is the choice of when to pay tax on a 2010 conversion. At this point, no one knows what tax rates will be in effect for 2011 and 2012. If the Bush tax cuts are allowed to expire, you might face a higher rate that could more than undo the benefit you’d receive by putting off the tax bill.
Kiplinger has developed a calculator to estimate the cost of converting part or all of your traditional IRA to a Roth. Answer three questions and we’ll estimate your tax bill under several different possibilities:
•If you pay tax on the conversion with your 2010 return.
•If you split the bill over 2011 and 2012 under three different scenarios:
1) The Bush tax cuts expire.
2) The Bush tax cuts are extended for all taxpayers
3) The Bush tax cuts are extended for all taxpayers except those in the top two tax brackets.
Our calculator will give you a rough estimate of the cost of converting to a Roth, based on certain assumptions, including that your income (not counting the conversion) remains relatively stable in 2010, 2011 and 2012. We also do not take into account any possible impact of the alternative minimum tax. The deadline for making a 2010 Roth conversion is December 31. By that time, we should know what the 2011 tax rates will be.