Saving for Retirement

When to Switch to a Roth IRA

Converting to a Roth makes sense -- if you can take the tax hit.

By Mary Beth Franklin, Senior Editor

From Kiplinger's Personal Finance magazine, May 2008

Conversions are a hot topic these days -- and we're not talking about the religious kind. Many readers want to know whether they should convert their traditional IRAs to Roth IRAs -- and pay tax on the converted amount -- when the income limits on conversions disappear in 2010.

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Jeff and Dawn Eales of Mission Viejo, Cal., are among the curious. "I believe when we retire in 20 to 25 years, tax rates will be considerably higher," says Jeff, 45. "I'm trying to determine whether we would be better off taking the tax hit in 2010."

Future tax rates are impossible to predict. But assuming higher rates, converting a traditional IRA to a Roth IRA makes sense, says Lester Detterbeck, a financial planner and certified public accountant with DWM Financial Group, in Charleston, S.C. However, for people who have large IRA balances, like Jeff and Dawn, a conversion could trigger a huge tax bill.

New rules. Under current law, you can't convert a traditional IRA to a Roth if your adjusted gross income is more than $100,000. Starting in 2010, and continuing in future years, that limit disappears. Regardless of your income, you'll be able to convert as much or as little of your traditional IRA to a Roth IRA as you like.

If your IRA is funded with the usual combination of deductible contributions and tax-deferred earnings, the entire amount you convert will be taxed at your top income-tax rate. If you convert to a Roth in 2010, you have the option of paying your tax bill over two years, in 2011 and 2012.

Income-eligibility limits on annual contributions to a Roth IRA -- currently $169,000 for married couples and $116,000 for individuals -- will remain in effect (and increase in future years to keep pace with inflation). But you can easily sidestep them now or in the future if you make nondeductible contributions to a traditional IRA and then convert the balance to a Roth IRA in 2010 and beyond. If your IRA is funded solely with nondeductible contributions, you will owe taxes only on the earnings when you convert to a Roth.

Not so simple. The Ealeses have about $73,000 in traditional IRAs, one-third of which stems from nondeductible contributions. That means two-thirds of any amount they convert would be taxed at their top rate. (And, no, you can't choose to convert just the nondeductible part. The portion that escapes taxes is based on the ratio of nondeductible contributions to the total IRA balance.)

In their 25% federal tax bracket, plus their 9.3% California tax rate, it would cost the Ealeses more than $16,500 to convert their current balances to a Roth (and probably more by 2010, assuming additional earnings). But the Ealeses' tax bill could be even more because the converted amount would be added to their adjusted gross income and could push them into a higher bracket.

Dick O'Donnell, senior tax analyst with Thomson Tax & Accounting, notes that the Ealeses don't have to convert all of their IRA balances to a Roth in a single year. Instead, they could convert a little at a time so that they don't bump up into the next tax bracket. But, he cautions, the current low tax rates are due to expire after 2010, and unless Congress acts, stretching out the conversion could also increase their tax bill.

Valuable benefits. If you are concerned about leaving a tax-free legacy, a Roth IRA trumps all other accounts, says Detterbeck. A Roth IRA has no mandatory distribution requirement, and your heirs can inherit the account tax-free.

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