Why You Shouldn't Convert to a Roth IRA

From the Wall Street Journal:

As 2009 came to a close, financial advisers geared up for an expected flood of clients looking to convert their traditional individual retirement accounts to Roth IRAs this year.

Conversions are indeed way up from previous years, thanks to the elimination of the income limit for those wanting to make the switch. But many clients who had expressed interest are deciding not to convert.

Conversion is attractive mainly because withdrawals from Roth IRAs, unlike those from traditional IRAs, are tax-free.

Moreover, Roth IRAs also have no withdrawal requirements; traditional IRAs require investors to begin making withdrawals at age 59½. Several brokerage firms saw conversions by their clients quadruple in the first quarter of 2010, compared with the year-earlier quarter.

However, financial advisers are finding that most clients wouldn't benefit, on balance, from a conversion. Here are the main reasons why:

1. The tax bite is too big.

Clients often come to advisers asking about the Roth IRA conversion opportunity without realizing the immediate tax implications: They will have to pay income tax on any money they move out of a traditional IRA into a Roth account.

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Roth IRA Change May Not Be ‘Game Changer’ for Savers

Earlier today I came across this fascinating article from Bloomberg.com, discussing the changes to the US tax code that would allow more taxpayers to convert to a Roth IRA. In the article, the author discusses how changing may not make as big of a difference as one would think, and provides several examples of why.

Changes to U.S. tax laws next year give high-income earners planning for retirement a decision to make: pay now or pay later.

Taxpayers making more than $100,000 a year in adjusted income will be allowed to convert to Roth IRA accounts from traditional IRAs after that limit is lifted at the end of the year. That means 16 million Americans, according to tax returns filed with the Internal Revenue Service in 2007, can consider whether they want to make tax-deductible contributions if they have a traditional IRA or pay the taxes up front and have tax- free withdrawals during retirement with a Roth IRA.

Which is better depends on future tax rates and how much the conversion will cost. It may not make sense to pay taxes today at a higher rate because many investors will be in a lower tax bracket during retirement, according to Tom Orecchio, a fee-only adviser at Modera Wealth Management in Old Tappan, New Jersey.

“From a tax perspective, I think when people do the math, it’s not going to be as game changing as they expect it to be,” Orecchio said.

Higher-income households that could benefit from the income limit changes are not rushing to switch, according to a survey released today by San Antonio-based United Services Automobile Association. The national survey of 1,259 adults between 45 and 64 years of age shows that for those with an IRA and a household income of $100,000 or more, 9 percent are planning to convert in 2010.

Tax Assumptions

Most IRA assets are held in traditional IRAs, based on a June report by the Investment Company Institute, a Washington- based trade group for mutual funds. Investors held $3.2 trillion, or 89 percent of IRA assets, in traditional IRAs at the end of 2008. Roth IRAs accounted for $165 billion, or 5 percent, of all IRA assets.

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Timing May Never Be Better On Roth IRA Conversions

From the ChicagoTribune.com:

Joe Cunningham is convinced that income taxes are going up, even for middle-class people like him.

Attempts to fix the economy can't work without an enormous tax increase, the Pasadena, Md., retiree said: "It will be on everybody who pays taxes, which ultimately always is the working class or retired working class."

For that reason, the 68-year-old wants to convert his traditional individual retirement account to a Roth IRA. By doing so, he'll have to pay regular income tax now on the funds he transfers to the Roth. But from then on, money coming out of the Roth will be tax-free. So no matter how high taxes go, Cunningham won't have to worry.

If he's right about taxes, his timing to convert couldn't be better.

Tax rates are historically low now. IRA account values also have fallen with the markets, so there are fewer gains to tax during a conversion. And the outlook for higher federal income taxes is good--at least for those in the top two brackets. President Barack Obama favors raising the rates on families making more than $250,000. Even if Uncle Sam doesn't raise income taxes on those making less than that, cash-strapped states might do so, said Ed Slott, an accountant and IRA expert. That's another factor favoring the Roth.

IRAs give you the choice of receiving a tax break upfront or on the back end.

A traditional IRA rewards you on the front end, where contributions often are deductible. Once you take money out in retirement, you pay regular income tax on the earnings and any deductible contributions.

Money goes into a Roth after taxes have been paid on it, but comes out tax-free in retirement. Basically, you're better off with a Roth IRA if you expect to be in a higher tax bracket in retirement than while working.

So should you, like Cunningham, make the switch?

There are several factors, besides the tax outlook, you need to consider.

Right now, only singles and married joint filers with adjusted gross incomes up to $100,000 can convert a traditional IRA into a Roth. Next year, that cap disappears. And if you convert to a Roth IRA next year only, you will be able to spread the tax bite over 2011 and 2012.

You shouldn't convert if you will need to take the money out of the Roth within five years. If you do so, you will trigger taxes on the earnings withdrawn, Slott said. Plus, you can be hit with a stiff penalty if you're under age 591/2.

"There is really no benefit today, or next year or two years" for converting, said Jim Sloan, a financial adviser in Friendswood, Texas. "The benefits are five, 10 or 15 years from now" when your Roth has had time to grow, he said.

Don't convert if you don't have money outside the IRA to pay your tax bill. Using IRA cash to pay taxes means fewer dollars going into the Roth. Plus, that cash will be subject to an early withdrawal penalty if you're under age 591/2.

As an alternative, you could convert only part of your IRA to reduce the tax bite to an amount you can afford to pay out-of-pocket, Slott suggested. For retirees who don't need the money, the Roth has another attractive feature: No required distributions after age 70 1/2.

To see whether a conversion makes sense for you, check out the Morningstar IRA calculator on T. Rowe Price Associates' Web site (troweprice.com). Click on "individual investors," then "tools and calculators."

Of course, there is no guarantee taxes will go up.

That's why Joel Dickson, a tax expert with the Vanguard Group, recommends a mix of traditional and Roth IRAs as a hedge against whatever happens to tax rates.

If you regret converting, you have a certain amount of time to switch the Roth back to a traditional IRA and have the money you paid in taxes returned, Slott said. You will need to contact the custodian of your IRA and file Form 8606 with your federal tax return to convert, Sloan said.

IRAs are highly complicated. There are so many potential traps that if you're not quite sure how to undertake a conversion, seek the help of a professional.

Take a Look At Tax Law When Converting An IRA

The News Tribune recently published a great article examining the tax laws surrounding the conversion of a Traditional IRA to a Roth IRA. You can check out a portion of the article below, but the full post can be found here.

Over the next two years, you are likely to see more people convert assets from Traditional Individual Retirement Accounts to Roth IRAs.

Three considerations make understanding the IRA to Roth conversion more important for many investors:

• Lower values of most IRAs as a result of the market correction.

• The prospect of increased taxes in our future.

• The elimination of an income limit in 2010.

With a Traditional IRA, when you take withdrawals of your contributions and earnings, they are subject to ordinary income tax. Also, once you reach 701/2 you are forced to take annual distributions. (These required minimum distributions have been waived for 2009.)

With a Roth IRA, as long as you’re over 591/2 and have held the account for five years, the assets grow tax free, there’s no tax on withdrawals and no requirement to take annual distributions if you don’t need the income. This way, more potential growth may be available for your later years or for beneficiaries of the account.

Determining whether or not to make this conversion can be complicated. You need to weigh the short-term consequences vs. the long-term impact. In order to make the conversion, you have to pay income tax on the amount converted. But if you can afford that hurdle, the long-term benefits may be worthwhile.

For many, a Roth conversion makes sense if you expect income tax rates, or those of your heirs, to rise. An increasing personal tax burden seems likely given the rapidly growing fiscal deficit due to bailout and economic stimulus packages.

There are different reasons driving Roth conversion decisions in 2009 and 2010. This year, investment declines during this recession have presented a more immediate opportunity. If your modified adjusted gross income is less than $100,000 in 2009 (filing jointly or single), you are eligible to make the move from Traditional to Roth IRA. And for many, the tax bill associated with the conversion will be significantly less than it would have been to make the same conversion at this time last year.