Now may be the best time ever to convert your traditional IRA to a Roth. Here's why.
ATTENTION IRA FANS: If you've been thinking about converting a traditional or SEP IRA to a Roth IRA, there's no better time than the present. Why? Low federal tax rates combined with account balances still depressed from the bear market have created a unique opportunity. But you'd better move fast. To take full advantage of this strategy, you might want to pull the trigger before the champagne starts popping on New Year's Eve.
The Case for Conversion
What, you may ask, makes a Roth IRA so much better than a traditional IRA? Qualified withdrawals from a Roth IRA are tax-free , whereas those from a traditional IRA are taxed as ordinary income. Unlike a traditional IRA, you don't get a deduction on your contributions, but for long-term retirement savers, those tax-free withdrawals give the Roth a definite advantage. (To see for yourself, click here.) To get the tax-free withdrawals you must meet only two requirements: (1) you must have at least one Roth account that's been open for more than five years and (2) you have to be age 59 1/2 or older. Easy!
What isn't so easy is getting lots of money into a Roth IRA so you can take advantage of that great 0% tax rate. Since you can only contribute $3,000 annually to these accounts ($3,500 if you'll be age 50 or older at year-end), it can take many years of contributions to accumulate a substantial balance. You can solve this problem, however, by converting an existing traditional IRA or SEP account into a Roth IRA.
Sadly, the conversion privilege isn't available to all. You can convert only in a year in which your modified adjusted gross income (MAGI) -- not including the additional income triggered by the conversion itself -- is $100,000 or less. This $100,000 limit applies equally to joint filers and unmarried taxpayers. Married persons who file separately are completely ineligible.
Assuming you meet the income qualification, there are no limitations on the size or number of converted accounts. But there is a tax bill. The Roth conversion is treated as a taxable distribution from your traditional IRA. In other words, in order for your account to grow tax free as a Roth, you're going to have to pay taxes on what you've accumulated so far. It's ugly, I know. But this negative factor is far outweighed by the following positive factors:
Consider a Multiyear Conversion
The extra taxable income you trigger by making a Roth conversion is added to your other ordinary income from other sources (salary, bonus, self-employment income, short-term capital gains, alimony and so forth). So if you convert relatively large IRA balances, it could push you into a much higher tax bracket. The conversion income would also increase your AGI, which can potentially trigger a bunch of unfavorable AGI-sensitive phaseout rules (such as the ones affecting the deduction for college tuition, the child tax credit and so on).
Thankfully, there's a solution to this dilemma. Consider converting your large traditional IRA balance (or balances) to Roth status in stages over several years (say three to five years). For instance, you could convert one-third of your traditional IRA balance this year and convert the remaining two-thirds in equal chunks during 2004 and 2005.
If this multiyear conversion strategy sounds good, you should probably start the drill before Dec. 31. That's because the sooner you get started, the better the odds that all the income triggered by your multiyear conversion program will be taxed at today's low rates. While it's almost certain any 2004 conversions will be also taxed at today's rates, things get murky after that. (Next year is an election year, after all.)
Things to Consider Before Pulling the Trigger
While making a Roth conversion is generally a tax-smart move, you still need to keep your wits about you. Why? Because you really know only one thing with absolute certainty: Doing a conversion will trigger a current income-tax liability. With that in mind, here's what to consider when evaluating whether the Roth conversion strategy is right.
Never Fear: You Can Reverse Ill-Advised Roth Conversions
Another great thing about the Roth conversion strategy is that you can always change your mind well after the fact. Believe it or not, you have until Oct. 15 of the year following the conversion year to recharacterize (unwind) your converted account.
Example: Say you convert two traditional IRAs into Roth accounts between now and year-end. In 2004, the converted accounts plummet in value because of crummy investment performance. In this unwelcome scenario, you would pay 2003 income tax on value that disappeared into thin air. That would be very bad! But relax. The tax law gives you an out. You have until Oct. 15, 2004, to recharacterize your two converted accounts back into traditional IRA status. It's as if the ill-advised conversion transactions never happened. So you won't owe any federal income tax on the now-unwound conversions. (If you've already filed your 2003 return by the time you recharacterize the accounts, you must file an amended return to get your money back.)
I've quantified the tax savings garnered by converting a traditional IRA or SEP into a Roth in two illustrative scenarios shown below. If you decide to convert, your actual results will depend on the variables explained in this article. However, you should always consult with your tax pro before pulling the Roth conversion trigger.
The case studies below assume you're thinking about converting a traditional IRA or SEP account currently worth $50,000 into a Roth IRA, and that you have 25 years to retirement. It's important to recognize that the money used to pay the conversion tax bill could have otherwise been invested in a taxable account until retirement age. So the true cost of converting includes the cumulative after-tax investment earnings you would forego on the dollars spent to pay the conversion tax. The following case studies take this factor into account.
Case Study 1: Same Tax Rate Now and at Retirement
Assumptions: 9% pretax rate of return on account balance between now and retirement in 25 years; 28% tax rate on income triggered by Roth conversion; 28% tax rate if traditional IRA is liquidated in 25 years; 7.2%* after-tax rate of return on cash used to pay Roth conversion tax hit (money that could have otherwise been invested in a taxable brokerage firm account until retirement).
*Of the 9% pretax rate of return, we assume 40% will be ordinary income taxed at 28%. We assume the remaining 60% will be long-term gains and qualified dividends taxed at 15% annually. These assumptions equate to a 7.2% after-tax rate of return.
Case Study 2: Lower Tax Rate at Retirement
Assumptions: Same as Case Study 1, except now assume a 25% retirement-age tax rate if traditional IRA is liquidated in 25 years.
Evaluation: Converting works best when the retirement-age tax rate is the same or higher than the current tax rate on income triggered by the Roth conversion. If the retirement-age tax rate is lower than the current rate, converting may still pay off -- but not as big.