To convert or not convert has been a popular question since 2010. Reuters.com recently published an article about Roth IRA conversions:
Of two minds about Roth conversion?
To Roth or not to Roth? As it turns out, you can sort of have it both ways.
By Amy Feldman
Mar 27, 2012
There are several factors to consider when to determine if converting an IRA to a Roth is the best financial decision. This article discusses six key issues to consider when thinking about a Roth conversion. The idea of having “it both ways” comes into equation with IRS rules allowing a conversion to be undone though recharacterization. If there were unforeseen conditions that work against your decision to covert, like a market downturn or a windfall raising your income level, you can choose to undo the conversion and wipe the slate clean by putting the money back into the IRA. Read more about the six tips shared below from the Reuters article.
- Covert only if you can cover the tax bill from non-retirement savings.
“Convert only if you can pay the tax bill from outside your retirement accounts, otherwise, you’re just eating away at your savings. Depending on your tax rate and what assets you’re converting, that tax hit could be a third of the account’s value or higher.”
- The longer the money can grow without withdrawals, the better case for conversion.
“The longer you have until you need the money, the better the Roth conversion, thanks to the value of tax-free compounding. But timing isn’t just about your age; it’s about when you might need that money.”
- Consider your future tax rate.
“While converting to a Roth may be worthwhile even if your income tax rate remains the same, it is an especially good deal if you expect your income tax rate to be higher in the future than it is now. And the possibility of higher tax rates in 2013, especially for high-income taxpayers, has provided a new impetus to convert sooner rather than later.”
- Funding a Roth has income limits, but converting an IRA to a Roth does not.
“While there are income limitations on funding a Roth (the phase-out starts at $107,000 for singles, and $169,000 for married filing jointly, for 2011), the removal of the income restrictions on converting to a Roth for those with modified adjusted incomes over $100,000 has led some financial planners to suggest that clients fund a non-deductible IRA and then convert it immediately to a Roth.”
- Remember, there are no special rules on taxes due on conversions after 2010.
“Special considerations for this year’s tax returns: If you converted any IRAs to Roths in 2010, and took advantage of the special rule allowing you to spread the tax due over two years, you’ll owe half the tax on this year’s return. If you converted in 2011, you’ll also owe tax on that conversion at this tax season since there was no special two-year tax deal in 2011. Don’t let this come as a nasty surprise at tax time.”
- You can change your mind – thanks to recharacterization.
“The Internal Revenue Services allows you to undo your conversion in a process called “recharacterization.” The biggest reason to recharacterize a Roth is if your investments go south. Say, for example, that you converted a $100,000 deductible IRA to a Roth, and the investments in it declined by 20 percent. You’d owe tax on the full amount, even though your holdings are now worth only $80,000. Ouch! To avoid that outcome, you simply recharacterize the account with your financial institution; the deadline for undoing 2011 conversions is October 15, 2012.”
Money Tree Software offers a robust Roth IRA Conversion Analysis through Distribution Solutions. The Roth IRA Conversion Analysis allows advisors to quickly and fully examine costs and benefits of potential conversions and generates a complete twelve-page illustration of conversion effects. Detailed calculation tables show precisely how taxes and opportunity costs determine the benefit of converting to a Roth IRA.