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To Roth or not to Roth? That's a popular question for investors as the year draws to a close. This year for the first time, anyone is allowed to convert a traditional IRA to a Roth IRA regardless of income. But what sounds like a great idea carries a potentially formidable price tag: Taxes are due at the time of conversion.
I'm an unabashed Roth enthusiast. Contributions are not deductible, but investment earnings compound tax-free and withdrawals are never taxed as long as you follow the rules. If you've got at least that much in earned income, you can contribute $5,000, plus $5,000 for your spouse, plus $1,000 for each of you if you're 50 or older. If you qualify to contribute, do it.
But whether or not to convert a traditional IRA to a Roth is not such a slam dunk. If you want to be sure conversion is right for you, you have to run the numbers for your individual situation — or ask your financial adviser or tax preparer to run them for you. I can, though, offer some information to help you decide whether it's worth the trouble.
Here are some situations in which a Roth conversion is likely to be a good deal:
A large percentage of your IRA balance is from nondeductible contributions. In that case, your withdrawal will only be partly taxable. The portion that comes from your nondeductible contributions isn't taxed. Unfortunately, you aren't allowed to convert only the nondeductible contributions.
Your income is temporarily depressed. If your income this year is lower than usual, there's a good chance that you're in a lower tax bracket now than you will be in the future. You might benefit by converting just enough to increase your income up to the level of the next tax bracket without going over.
You won't need the money in your IRA for a long time, if ever. The longer the compounding period, the more benefit you get from a conversion.
You can pay the taxes on the conversion from other funds. If you would have to withdraw from the IRA to pay the tax bill, the numbers are unlikely to work. For most people, this is an absolute requirement to make a conversion worthwhile. However, conversion still might be beneficial in situations like these:
• Your income is so low you don't pay taxes. Convert enough of your IRA to at least take you up to the threshold at which you would be taxed.
• Your income is low, but you've got a large IRA. Convert some of your IRA now and you reduce the size of your traditional IRA, which will reduce required distributions after age 70 ½. It makes sense to take money out now if required distributions would bump you into a higher tax bracket later.
• You want to leave your IRA to your kids. You never have to take distributions from a Roth, so you can leave them intact and tax-free for your kids. This makes the most sense if you are in a lower tax bracket than your children.
• • •
On the other hand, there are some people for whom Roth conversions are unlikely to pay off in any significant way:
You're in a higher tax bracket now than you expect to be in the future. Some people's taxes really do go down in retirement. If you turn out to be one of them, you'll pay less in taxes by waiting.
You need to withdraw money from your IRA in the near future. Conversion will cost you taxes up front.
You want to leave your IRA to charity. Charities don't pay taxes, so there's no point in paying taxes that might be avoided. And we can hope Congress brings back the option of making direct contributions to charity from traditional IRAs.
As you look at your own finances, remember that this isn't an all-or-nothing decision. And if you do convert this year, you have a choice of paying all the taxes on your 2010 return or spreading them over 2011 and 2012.
Helen Huntley is a former Times personal finance editor and currently a fee-only financial adviser with Holifield Huntley Financial Advisers in St. Petersburg (holifieldhuntley.com).
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