Jamie's Corner: Roth Conversions in 2010

You've probably been hearing the old adage ever since you first met with a financial planner to discuss your retirement: there's more than one way to tax a retiree.  Indeed, under the sometimes ludicrously complicated retirement savings provisions of the tax code, workers are either taxed before money is put into the retirement savings vehicle (Roth IRA) or when the money is withdrawn (Traditional IRA).  But, until this year, converting a traditional IRA into a Roth was only an option for those with Modified AGIs of under $100,000.

Enter 2010 and the no-limit Roth conversion.  To a tax-year already characterized by both confusion and opportunity (think estate tax), no-limit Roth conversions have added yet another layer of both.  Along with abolishing the long-standing income limits on Roth conversions, the 2010 law permits taxpayers who convert this year to report the transaction over two years starting in tax-year 2011.  Although the new law makes approximately 13 million otherwise income-barred households Roth-eligible, a new study conducted by Fidelity Investments found that most of these taxpayers don't even know it[1].  But the study notwithstanding, both Fidelity and Bank of America reported record conversions in the first quarter.[2]

So to convert or not to convert, that is the 2010 retirement question.  The almost-always-right, but rarely-helpful answer is "well, it depends."  And according to Rande Spiegelman at Schwab, it depends on your predicted future tax bracket, your time horizon, and your ability to pay tax on the conversion with non-IRA sources.[3]

If you are currently a high-bracket taxpayer, but will likely be low-bracket in retirement, converting now might not make sense.  Since investment growth is tax-free in both traditional and Roth IRAs, there's no advantage to paying higher tax today when you could pay lower rates on withdrawals later.  Alternatively, for the same reasoning, Roth conversions make a lot of sense for people early in their careers who expect to retire in a higher bracket then they are currently in. [4]

In addition for Spiegelman, if you have to withdraw from your current IRA to fund the taxes on the conversion, you're losing the Roth advantage.  This makes sense because the money you pull out of the IRA to pay taxes today would have grown tax-free if it had been left alone.  And be aware that you can't avoid the conversion tax by converting only the after-tax portion of your traditional IRA.    Indeed, the government treats every converted dollar as if it were a representative sample of all of the traditional IRAs in your name.    So, if you have a total of $200,000 spread amongst three IRAs and, over the years, you have made $50,000 in after tax contributions, 25% of any conversion, no matter how small, would be tax-free.

My cursory experiments with an online Roth conversion calculator (here) seem confirm Spiegelman's suggestions.  For instance, when I entered my current age (29), a $10,000 IRA balance, and indicated that I would be paying conversion taxes with non-IRA Assets, the calculator estimated that my monthly after-tax take-home would be $1355 under Roth and $1164 under a traditional IRA.  On the other hand, when I ran the same numbers but indicated that I'd be funding the conversion tax with the IRA, both resulted in an $1164 monthly after-tax take-home. 

And while the consensus amongst commentators seems to be that a Roth conversion may not benefit everyone, one author, John D. Bledsoe, feels that all eligible taxpayers should convert immediately.  Per Bledsoe, since the law allows 2010 conversions to be "recharacterized" (undone) until October 17^th, 2011, taxpayers "should convert first and run the numbers later."[5]    As the recharacterization deadline approaches, taxpayers will have more information (including Roth fund performance, tax rates, changes in current and predicted income) upon which to base their conversion decisions.

Bledsoe's theory nothwithstanding, Roth IRAs may not be for everyone, but under the right conditions could lead to substantial tax savings. It's worth noting, however, that all of these suggestions assume a certain amount of consistency in the tax law.  A future change in tax rates and brackets could have a significant effect on how valuable a 2010 Roth IRA conversion ends up being.