Considering conversion?
The issues aren’t quite the same as those one faces when considering the deepest aspects of personal faith and religious doctrine, but a “Roth conversion” can pose some difficult issues for investors nonetheless. And we’re going to hear much more about this going forward because of a scheduled change in the law: Unless something unexpected happens in D.C., come 2010 there will no longer be income limits on Roth IRA conversions.
There will be a lot written on the issue of whether one should convert or not, as well as endless articles describing all kinds of “strategies” to potentially leverage the change (some legitimate and others more questionable). For me, three things are important in considering this kind of “conversion”:
1. First and foremost is how strongly you feel about your future income tax rates. If you feel strongly that there is a significant chance your income tax rates will be higher in the future, then having some money in a Roth allows you to “hedge” that risk by paying taxes at today’s rates. Of course, you should note that while the Roth rules currently stipulate that no income taxes are owed on qualified Roth withdrawals, tax laws can change. So while the Roth clearly offers some protection from taxes, it’s not an ironclad guarantee.
2. Second is that you have to recognize that $1 of after-tax wealth is more than $1 of before-tax wealth. What this means is that by converting a $10,000 pre-tax IRA to a $10,000 post-tax Roth IRA, you have effectively put more resources into your IRA account. An example: If your income tax rate is 25%, your $10,000 pre-tax IRA is worth $7,500 of goods and services. Your $10,000 post-tax Roth is worth $10,000 of goods and services. In other words, even if the dollar amounts in traditional and Roth accounts are the same, the Roth gives you an ongoing tax break on “more” wealth. This is why, to properly compare the tax advantages of the two dollar-for-dollar, most quantitative analyses of Roth versus traditional—including Vanguard’s—include a taxable “balancing account” along with the traditional IRA. What you see is that if tax rates don’t change over time, the two IRAs actually offer identical tax benefits per dollar of after-tax IRA wealth. It’s just that you can generally get more after-tax wealth into a Roth. In practice, most people in the real world aren’t going to set up an additional savings account alongside their traditional IRA. So a Roth conversion is a great chance to save more, assuming you can pay the taxes you’ll owe on the conversion from a source other than the converted IRA.
3. A last consideration is how focused you are on spending the money in retirement. A big advantage of a Roth IRA is that you don’t have to take minimum distributions in your lifetime. That means you can keep the money in the “tax-free” wrapper a very long time. This is less of an advantage if you see yourself spending regularly from your IRA in retirement.
Obviously, everyone should consult a tax advisor about his or her own situation. But a Roth conversion in 2010 could offer some significant benefits to a lot of investors. And in all the noise and “strategizing” you’re going to hear in upcoming months, it may be important to stay focused on the basic issues.
The key point was made in the first of your three points- ‘the Roth is not an iron clad guarantee of no future taxes’. Do you trust a future congress, desperate for revenue, to honor the past promise of no taxes ever on a Roth? They will pontificate and then in the name of ‘fairness’ decide that the Roth was too generous a ‘gift’ and tax the proceeds. If you convert you will pay taxes now- that is certain. Whether it will be tax free in the future is not. There seems to be a certain wisdom in defering taxes as long as possible. As with all investment decisions there is an up-side and a down-side. In this case the downside (taxes on the conversion) is certain, the upside (future tax freedom of the proceeds) is not.
Mr. Ameriks, I appreciate your caution that tax laws change and there is no ironclad guarantee that qualified distributions from a Roth IRA will continue to be free of income tax. Most commentators fail to communicate that warning. I think it is very likely that eventually there will be a surcharge, or a tax on earnings, or a tax to the beneficiary. The appetite of government for more power and control over the lives of citizens is boundless.
One additional consideration is that Roth withdrawals do not add to taxable income, and therefore do not increase the proportion of Social Security benefits that are taxable.
I plan to switch to a Roth IRA. Should I (or can I) set up a shell account now and fund it early in 2010?
The problem I worry about as a 70′s plus senior with a regular IRA is that the RMD gets larger each year, putting me in a higher and higher tax bracket. Even though I gained a tax advantage putting the money into the IRA, the tax I avoided was much less than the tax now due on the RMD. How does all this factor into the wisdom of conversion to Roth?
For those considering converting the funds now in a traditional IRA to a Roth IRA ,what about the losses that occur due to the compounding that doesn’t take place because of the taxes that must now be “rendered” ? When I think about this and the possibility of our “Benevolent Uncle” changing his mind about no taxes ever during retirement, I am somewhat inclined to ” look the gift horse in the mouth”. Am I on the wrong track here?
Many past changes to tax laws governing retirement savings have included grandfathering clauses. An example would be the tax reform act of 1988 where previously 403(b) plans had no withdrawal restrictions. The 12/31/88 balances were grandfathered to continue to have no withdrawal restrictions. Post 1988 contribtions and earnings are subject to the restrictions we know today. In considering whether or not future Roth distributions might become taxable, it is reasonable to think there will be some form of a grandfathering clause. Roth investments should not be discounted as a sound retirement planning tool becuase of a fear that the Gov. may impose a tax sometime in the future.
Let’s say I am sitting on a combination of unused short and long term capital losses that I can carry over from previous years. Can I use some or all of those losses to offset income taxes owed on traditional IRAs converted to Roth IRAs next year? Does your answer differ if those traditional IRAs have a large non-deductible IRA component? Thanks!
For those people who contributed after-tax money into a traditional IRA in the past, it may make a lot of sense to convert a large portion of that traditional IRA to a Roth IRA while the opportunity is available. This is especially true if no pre-tax money had been contributed, so taxes would only need to be paid on any growth that has occurred. There is a possibility that most of the money in the traditional IRA will not be taxable during the conversion if the IRA had lost a significant portion of its growth during the recent bear markets.
Even if taxes on growth are imposed in the future, there would be no significant loss due to changes in the tax laws, and there is a good chance that all of the money in the IRA would grow completely tax free.
Yes it’s true “Roth is not an iron clad guarantee of no future taxes” and “tax laws can change”. But why not consider the possibility of changes to the tax treatment of traditional IRA’s: RMD’s could be increased. The age at which RMD’s start could be lowered. A surtax could be implemented on Trad. IRA’s that have “more than a fair share” of retirement assets. Maybe I haven’t thought of all the possibilities.
Do you trust a future congress, desperate for revenue, to honor the past promises with respect to traditional IRS’a?
The big bet seems to be, “Will I really be in a lower tax bracked when I take the Money out?”. I think marginal rates will undoubtedly go up. However, I have hard time believung I will still be in the top bracket in retirement. I will likely do both Pret Tax and Roth.
What date do you use to determine your IRA value for converting to ROTH IRA? Is it the end of 2008 if converting now at the end of 2009?
And is the value based on combined IRA’s of both husband & wife’s IRA’s or just the one who is converting their IRA?
If one is lucky and rich enough to be subject to Federal Estate Tax, consider that conversions from a Traditional IRA to a ROTH IRA lower the amount of estate tax due because you have lowered your Total Estate by the amount of the federal income tax paid. State Estate taxes can also be lowered with the same logic. Another question to ask yourself is: “What amount can I convert without throwing me into the next higher tax bracket?”
No one addresses the dilemma some people face who have considerable assets already in their non-Roth IRA’s. I am speaking of assets in the neighborhood of $750,000 to well over the $1 million mark. To convert those IRA’s to a Roth IRA involves serious tax payments over a very short two-year period (2010-2011). Coming up with the amounts needed to cover the taxes on such IRA’s is in my opinion, the primary issue as to whether such a conversion is even practical, given it could deplete much of one’s non-IRA assets.
How about someone addressing that issue as well?
A very poor article. It omits several clear points -
1. the value of tax deferral. To convert is to accelerate taxes. This is a big disadvantage of conversion.
2. the younger you are, the more advantage to conversion. Conversion doesn’t work so well for anyone over age 70.
I have a 401(k) from a former employer that I’d like to convert to a Roth IRA. Do I need to move the funds to a traditional IRA before converting to a Roth, or can I convert directly to a Roth IRA?
Great to have a blog like this where I can read the comments by people more astute than myself. Thanks to you guys for teasing out the above issues; hope that the author of the article writes a follow-up.
I thought this was a good article for its length, especially para 2.
Vanguard has an 11-page article on Roth Conversion at this link: https://personal.vanguard.com/us/literature/search?searchInput=S619&search_mode=true
Could you please: a) run a few mathematical scenarios on converting to Roth IRAs regarding several different tax brackets?; b) when paying diferred the taxes on the conversion SHOW again several models of how it works.
Thank you,
I am wondering if there is a way to dollar cost average the conversion from a traditional to a roth IRA? Instead of move all money at one time, can you move 1/12th each month?
Nice succinct article covering the key points. Regarding future tax laws, I agree with the vast majority of published articles that express the expectation that the Roth is likely to remain (income) tax free. Far more likely than a change to that, in my opinion, is increased taxation of consumption in the form of sales taxes, gasoline, tobacco, and alcohol excise taxes, and indirect taxation by including Roth income in determining taxability of other income (such as Social Security benefits) as the interest on municpal bonds is now. These are very real risks no doubt but need to be considered in the context of our current historically low marginal tax rates.
As for the compounding issue, you still benefit from compounding after conversion. If you use “outside” money to pay the taxes, you are effectively increasing your retirement savings which is especially valuable if you have maxed out your tax-deferred options such as 401(k) and deductible IRA plans. Basically you want to convert just enough to pay taxes at a rate that you are confident is lower than the rate you will be paying when you take the money out. (Yes, it’s break-even if you’ll pay at the same rate later but I think you should think of that as a safety cushion.) There is no hurry — no need to convert all of your pre-tax IRA money at once (you could convert monthly or quarterly or wait a few years before starting) or ever (certainly don’t deplete your other assets too much).
Since the income limitation on Roth contribution was not lifted in 2010, I was wondering if I could contribute to non-deductible IRA in 2010 and turn around and convert it to Roth in the same year(2010).
Traditional IRA’s become a problem when one has so much in them that the annually increased RMD triggers a higher tax bracket or tax on social security. My mom is pretty much stuck with this problem because the RMD is already hitting her hard. Older retired people often find themselves in the higher single’s tax bracket due to death & divorce. Its not too late for me. I’m married and have two kids so each year I convert as much to the Roth IRA as possible such that I don’t jump to the next tax bracket. I don’t have to eliminate my tradition IRA, I just have to limit its size so that the RMD doesn’t get too big upon retirement age. Also for Congress, increasing a tax is hard, creating a new tax is harder, but taxing something twice like Roth IRA’s would cause unacceptable political fall out thus unlikely. Congress will tax the least vocal group perhaps dead people (ie. ANY AND ALL THINGS INHERITED).
There is some confusion about the $100K income limititation for converting a traditional IRA to a ROTH beyond 2010. Some tax/financial planning web sites indicate that “the special tax provision removing this income limitation applies to conversions done in 2010 only” while other web sites indicate that “starting in 2010, taxpayers with modified AGI of more than $100K will be allowed to convert a traditional IRA to a Roth IRA. This change applies to all years beyond 2010.” IRS Pub 590 (2009) states: “Beginning in 2010, the modified AGI and filing status requirements for converting a traditional IRA to a Roth IRA are eliminated” and “For tax years starting in 2010, the $100,000 modified AGI limit for conversions to Roth IRAs is eliminated.” So, if my AGI exceeds the $100K in 2011, 2012, 2013, etc., will I be able to convert a portion of my traditional IRA balance to a Roth, thus spreading out my tax liability over those several years?
I have three questions:
1. If I already have an existing ROTH IRA account, can I convert my 403(b) account (fully or partially) to the pre-existing ROTH acct? Or, do I need to set up a new ROTH to receive the converted funds?
2. Is it true that the tax due on the amount converted in 2010 can be deferred and paid in two equal portions in 2011 and 2012?
3. Regardless, does one still need to wait 5 years after conversion to start withdrawing funds from the ROTH account–tax free?
Thank you…
I am a teacher and I have a 403(b)(7) retirement account into which I make tax free contributions along with a Roth IRA account. For 2009 I do not qualify to purchase Roths, because my adjusted gross income is too high. I was told I could use after tax money to buy a traditional IRA (nondeductible) and then convert it to a Roth as soon as its established, only having to pay tax on the little money the traditional IRA might make before the conversion. Is this true? Is a 403(b)(7) an IRA? Will I have to pay a percentage of tax on my 403(b)(7)? Any advice would be appreciated?
I am confused. In your discussion above you ignored the likelihood that the accounts will grow over time. If I defer taxes on contributions made to a traditional IRA today–I will have to pay taxes on the contribution and the earnings when I retire. So, if I put $10K in both a traditional and a Roth IRA today, and say those contributions have doubled when I start taking distributions, I will have to pay taxes on $20K from the traditional, while only paying taxes on the $10K I initially put into the Roth. Thus regardless of the risk of future tax changes, it is certain (unless my IRAs decrease in value) that I will pay, in absolute terms, much more in taxes over my lifetime with a traditional IRA.
Vanguard’s Roth Conversion Calculator does not seem to take into consideration the future value of the money used for the taxes on the conversion – this makes the benefits appear much greater. Fidelity’s Calculator does take this into consideration by deducting the future value of the tax payment from the Terminal Roth value.
I recently converted my and my wife’s Vanguard Traditional IRAs to Roth IRAs. We are in the highest marginal income tax bracket and expect to remain so in the future. Given the fact that the highest federal marginal tax rate is due to increase in 2011 and beyond, my question is as follows: I understand that the tax due on conversion to a Roth IRA can be spread over 2011 and 2012. However, would the tax to be paid over the two years be based on the tax liability on the day of conversion, that is at the 35% tax rate when the conversion was made, or would the payments owed in 2011 and 2012 be based on the 39.6% (or higher) marginal rates in those years? Obviously, the answer will determine whether we pay the taxes this year or defer them..
I’m starting a ROTH IRA conversion. For instance, if I was to convert $2000, what tax % rate is used to figure out how much I would owe in taxes? Vanguard says they can’t help me, because they don’t know how much I would owe in taxes. Perhaps if they told me what tax rate to use then we’d know.
How is Vanguard’s ‘Roth Conversion Calculator’ calculating how much I contribute each month if I’m not entering that information? Considering, I would like to be able to do that. It’s automatically inputting a hypothetical amount that’s not near what I would input.
I know I want to declare my conversion income as 2010 income. . . however, I’m having a hard time finding a good answer as to when during the year (or even in 2010 vs. when I file in 2011) I needed to pay estimated tax to avoid potential underpayment penalties. . .
Re Oct. 1 blog: I recently contacted IRS concerning estimated tax requirement on the conversion. I gave the agent numbers from last year’s return plus the amount I was going to convert. She ran the numbers and told me that I didn’t have to pay the tax until I file in April, 2011. (I just hope she right!)
My reason for converting to a Roth is for estate planning. I’m doing it in stages to minimize tax consequences. I am POSITIVE that taxes will rise and my kids would be paying much more after my passing! I have never seen taxes decreasing, locally or federally, thanks to our politicians! I won’t be spreading this year’s conversion over 2 years because I’ll be putting in similar amounts year after year. We are fortunate (frugal) enough that we take the MRD only because it’s required by law. Just make sure that the rollover is not part of your MRD.
I am following a similar plan to that of the individual that posted on 10/23/2010 at 2:08 pm. I am slowly converting my Traditional IRA assets into Roth assets – primarily (though not solely) for purposes of estate planning. Otherwise ultimately my heirs must pay income taxes, as a result of my choice to defer the income taxes associated with these assets.
I have been incrementally accomplishing this conversion process for some time now, and I am careful to convert just enough each year to always remain in my planned tax bracket. And the prior poster was correct – if RMDs are required to be processed, the RMDs cannot be part of the Roth conversion. In order to facilitate this annual conversion effort, I have converted most of my non-IRA income-producing assets into muni-bonds. Because I do not pay income tax on this income, it permits me enough room within my tax bracket to convert a fairly large portion of Traditional IRA assets each year into Roth assets. I have calculated that the conversion process should be totally complete about 15 years from now. Chances are that either my wife or I (or both of us) should still be around to finish it by 2025. And Roth IRAs will be so much more valuable and easier for the children to manage.
One of the issues I have not seen addressed is whether conversion to a Roth might increase one’s AGI in the year of conversion high enough to require additional tax payments due to the Alternative Minimum Tax (AMT) provisions currently in place. If so, the initial tax of conversion may be significantly greater than reflected in straight rate comparison tables.
If I convert to a Roth now, do I have to wait 5 years to withdraw any money tax-free?
Good Day,
Regarding conversions from a Traditional to a Roth IRA, it would be grand if you could clearly express if the maximum yearly contribution level of 5k applies to both ” annual contributions” after the conversion is completed as well as/as not the converted amount…In other words if I wanted to initially convert/rollover 10k, is this possible since the “rollover” amount is not being pulled from current year net earnings?
Also, please explain the flexibility of dividing a current IRA into mulitiple IRAs all at once. How long must one wait before re-converting/re-rolling over one IRA into another?
Always please “clearly express” a universal sample of: all upfront rollover fees, ongoing operating fees, annual fees…right up front on the Vanguard Home Page, rather than causing a prospective customer to fish for hours on your internet site!