1) Do you have enough money outside of your IRA to pay conversion taxes? 2) Do you expect your tax rate after retirement to be the same or higher? How you answer will tell you whether the conversion will save you money over the long term.
Deciding whether to convert a traditional IRA to a Roth IRA shouldn’t take rocket science, says Paul Jacobs, CFP, client service manager at Palisades Hudson Financial Group’s Atlanta office.
Ask yourself just two questions first:
“Do I have enough money outside my IRA to pay the additional tax caused by the conversion?”
“Do I expect my tax rate when I’m retired to be the same or higher than it is now?”
If you can answer “yes” to both questions, a Roth conversion will probably save you a lot of money in taxes over the long term, he says.
Question 1: Why you need ready cash to pay the additional tax?
“By paying the tax with funds in a taxable bank or brokerage account, you’re effectively swapping tax-inefficient assets for tax-efficient assets,” Jacobs says.
But if you withdraw money from your traditional IRA to pay the tax, you’ll have less to put in your Roth.
All earnings in a Roth are income-tax-free forever, as long as you don’t remove them before age 59½. But regular IRAs are tax-deferred, and they bigger they grow, the greater your future tax liability.
Question 2: How can you tell what your future tax rate will be?
If you’re wealthy, it almost certainly will be at least as high—and probably higher—than now. The top federal rate is scheduled to rise from 35 percent to 39.6 percent in 2011.
“With federal and state governments running huge deficits, it’s hard to imagine tax rates going anywhere but up for high-net-worth individuals,” Jacobs says. “If you can pay the tax now at a lower rate than you would in the future, that’s a winning proposition.”
2010 is the first year that everyone, regardless of income, is allowed to convert.
For most people, estimating your future rate is trickier. You have to look at all your sources of income in retirement as well as future deductions. (For instance, your deduction for mortgage will go away once you’ve paid off the loan.) Make sure to include both state and federal taxes in your calculations.
If you expect your tax rate to be lower in the future, you’re better off leaving your traditional IRA alone, rather than triggering any taxes now, Jacobs says. Also, making a large Roth conversion today can kick you into a higher tax bracket. Spreading the conversion over several years may solve that problem.
But don’t turn down the idea of a conversion without doing the numbers.
“The federal government may have given you the opportunity to save tens or even hundreds of thousands of tax dollars - if you’re willing to deal with some complexity,” Jacobs says.
Unlike diamonds, a Roth conversion isn’t necessarily forever. If it doesn’t work out, you can undo it with a “recharacterization” - but that’s another story.
Palisades Hudson Financial Group is a fee-only financial planning firm headquartered in Scarsdale, NY. It offers estate planning, insurance consulting, trust planning, cross-border planning, business valuation and appraisal, family office and business management, and executive financial planning. Its sister firm, Palisades Hudson Asset Management, is an independent investment advisor with about $950 million under management. Branch offices are in Atlanta and Ft. Lauderdale.