Roth Conversions: The Clock Is Ticking

As you probably know, beginning January 1, 2010, Washington loosened rules for converting traditional IRAs (with taxable withdrawals) to Roth IRAs (with tax-free withdrawals). The full amount you convert (minus any basis in nondeductible contributions) is taxed as ordinary income now when you convert. However, future withdrawals will be tax-free.

In addition to tax-free income, Roth IRAs have no minimum required distributions. This lets accounts compound tax-free even longer for your heirs. And Roth distributions arent included in provisional income used to determine whether Social Security benefits are taxable.

So, converting your IRA may be worth a fortune in savings. But the decision might be anything but a no-brainer.

Converting makes sense under the following basic condition: If the tax you pay today is lower than the tax you would otherwise pay to withdraw funds tomorrow. The challenges lie in 1) calculating how much you will actually pay today, and 2) predicting how much you might pay tomorrow.

The general rule of thumb is that if tomorrows tax savings justify todays costs, then it makes sense to pay now for bigger savings tomorrow.
The first challenge calculating how much the conversion costs today is relatively straightforward. A Roth conversion affects your current-year income in several ways. Some are obvious, others are easy to overlook, but all are predictable. Possible results include:

Converting a regular IRA to a Roth increases regular taxable income, which can push you into higher tax brackets.
Converting accelerates phase-outs for medical and dental expenses, miscellaneous itemized deductions, rental real estate loss allowance, child tax credits, college tax credits, and similar breaks.
Converting can subject more of your Social Security benefits to tax and can cost you certain Medicare benefits as well.
Converting may affect college financial aid decisions.
Recognizing income from a Roth conversion can also subject you to Alternative Minimum Tax.

The second challenge predicting how much tax you will pay tomorrow if you dont convert is harder. In fact, if your time horizon is long enough, its almost impossible. Think about it this way: When Regan took office in 1981, the top marginal rate stood at 70%, yet when he left in 1989, the top marginal rate had dropped to just 28%. If you had converted just before Reagan took office, with plans to take tax-free funds a decade later, you would have regretted that decision.

Plus theres one other factor to consider. If you convert before January 1, 2011, you can elect to report half of the resulting income in 2011 and the other half in 2012. However, this makes the challenge of calculating the cost of conversion harder. For example, tax rates for the two highest brackets are scheduled to rise in 2011. So be careful before you convert an account that might push you into those brackets.

But if you get it wrong, there is a way out. If you convert and then later change your mind, you can undo that conversion by October 15 of the year after you convert. The do-over rule can be a lifesaver if you miscalculate the cost of converting or if the value of your account drops significantly after conversion (forcing you to pay real taxes on phantom assets).

Heres the bottom line. A Roth conversion is rarely an obvious call. (Its even more rarely a do-it-yourself call.) But its usually worth considering, especially now with the opportunity to stretch the taxable income over the next two years. Call us if youre interested in exploring whether you can save tens or possibly even hundreds of thousands of tax dollars down the road.