Converting an I.R.A. Into a Roth? How’s Your Crystal Ball?

Tax laws change, making the decision to turn a regular individual retirement account into a Roth potentially difficult.

Comments: 34

  1. Do you remember when we were told that Social Security benefits would be tax-free?

  2. Allen, if I'd had more room in the story I would have ticked off a list of things that people never thought would be taxed (or taxes that people did not expect to change dramatically) that did ultimately change a great deal. But social security is a big one.

  3. I have just recently converted some IRA funds and have thought many of the pro/con thoughts mentioned here. My decisions were based on the following:
    1) Easy, easy. You don't have to go whole-Roth hog. There are unknowable risks of taxation ahead, a have-nots revolt, a younger generation revolt, a "national emergency." Roths will be fat, juicy, ripe low-hanging fruit for taxers.
    2) On the other hand, don't walk away from a conversion. No taxes on gains, no mandatory withdrawals after 70, much less to convert (ouch!) since the crash, passing some on to heirs--all argue that this is an great opportunity. Also because it is so good a deal, the Roth door may soon be closed.
    3) To tax Roths down the road would be a faith-breaking, contract-voiding act that would poison confidence in the US for decades, an arrogant act that only some future Cheney clone would dare undertake.

  4. A major advantage of the conversion to Roth is that you are NOT required to withdraw funds (taxable) from your IRA starting at 70.5 years. With a standard IRA, you are required to take the same annual amount of withdrawals starting at 70.5, until you die. With a Roth, you can take it whenever and in whatever amounts you need.

  5. I have been making Roth conversions for a number of years.

    In terms of your even suggest that Roth distributions might be taxed in the future is some sort of scare tactic on your part and completely illogical. It would be like taxing withdrawls from a savings account, very different from taxing social security. If it ever looked as if it might happen, people could immediately empty out their Roth accounts with few tax consequences.

    The tax code always changes, but right now as a retiree taking distributions, it seems that the traditional IRA or 401K is a big scam, even with the initial tax decuction.

    People like Dick Cheney get huge capital gains on their investments outside of traditional retirement accounts and pay a maximum tax of 15% on that income. They can harvest losses.

    The little people as retirees are paying high ordinary rates on distributions. Our capital gains don't receive the favorable tax treatment and we can't harvest losses.

    I wish the Roth was available when I was young.

  6. Gene, it's not a scare tactic. All sorts of people way smarter than me think some sort of Roth change is a given in the next couple of decades -- and not just people who have a financial interest in scaring clients so as to charge them hourly or annual investment management or financial advice fees.

  7. As if it isn't enough to have to try to make educated guesses for our retirement investments, now we need to consider "tax diversification" in our planning. Given that it is impossible to logically guess the next tax law changes, is it any wonder that Americans throw their arms up on despair?

    We put in the maximum into our tax-deferred retirement accounts, we are paying off our mortgage early, we own our cars free and clear, we live on one of two incomes and don't keep balances on our credit cards. We have our emergency cash cushion. The small amount left each month goes into a large cap mutual fund. There's not enough left to worry about "tax diversification." And I suspect we are better off than most.

  8. Question for anyone out there who really knows the answer.

    I am 66 yrs old and thinking of converting a substantial amount from the traditional IRA to a Roth to take advantage of the 2010 opportunity.

    Currently I have a "stretch" IRA which allows my heirs to defer distributions over an extended period based on their ages. Can I do the same thing with a Roth IRA. This would allow my heirs to earn tax free income for the same extended period rather than to simply defer the taxes until they make withdrawals.

  9. Maybe the withdrawals will be "tax free" but will count as income for determining items such as the amount of the retirees medicare monthly payment or determining how much of social security will be taxed. With the deficits in the future for these programs, these changes seem likely to me.

  10. Taxes, schmaxes. The important thing is to save, period.

  11. As a CPA, I have reviewed this many ways with my clients. The article doesn't mention the fact that IRA withdrawls at retirement usually make your Social Security income taxable. Not good. Additionally, a lot of states give you some amount of distributions from a retirement account tax free after a certain age. For most people, that is the amount of money I recommend to convert, especially if the market has taken a big hit and you are transfering fund while the market is low and you have cash to pay taxes. A Roth IRA is best for most people to begin with, especially if there is no company match of contributions in other tax deferred plans. No step up in basis for normal retirement plans if you or your spouse die. Not good. Most people will be in the same or higher tax bracket after they retire by the time you add state taxes and the tax on social security income. Your social security income will probably eat up your state retirement tax exemption. Go to a good CPA and have him/her run your taxes both way. My clients tell me how much they have in their retirement accounts, forgetting the hugh tax liability they or their hiers will have to pay.

  12. If you do the math, you will find that transferring money from a traditional IRA to a Roth and paying tax on it now yields EXACTLY THE SAME amount of money on withdrawal (after paying tax on traditional IRA withdrawals then) IF your tax rate is the same on withdrawal as it is now. If your tax rate is lower when you withdraw, you will get less if you transfer to a Roth.

    So besides the administrative advantages of mentioned above, the advantage of a transferring to a Roth is certainty - if the tax rates go up without Roth withdrawals getting taxed, then you win. If legislators wanted to be "fair", then when they increase tax rates they might tax Roth withdrawals at rates equivalent to the tax rate increase. That would maintain the financial equivalence between Roth and traditional IRA.

    When you are depositing to an IRA, Roth has the advantage that depositing $2000 to a Roth is equivalent to depositing, say, $2800 to a traditional IRA if you have to earn $2800 pre-tax to have $2000 left after tax. I.e. with a Roth, it is as if you get to deposit more.

  13. I am 19. I was planning to open a Roth IRA this year. After reading this article, I have reservations, but I don't know of a better option at this point.

  14. Olivia, I think it's fantastic that you're starting a Roth at age 19. Go ahead and do it. As you save more money, however, it would be a good idea to consider saving some of it in taxable accounts, some of it in a 401(k) or similar workplace retirement plan and perhaps other places too, just so you've hedged your bets on the tax side.

    Congrats on starting so early...

  15. There is another nasty little trick the Feds could do. It could keep its tax "contract" with the Roth account holders and say that investment gains in those accounts remain free of tax, but then "means test" Medicare. That is, they could say that "if you have the means to pay for your later-life health care expenses, then you must use those means before you get the full Medicare benefit. And, that includes the value of your Roth account.

  16. Wow. Contracts mean nothing any more do they? If the government announces that it has "changed it's mind" about taxing Roth IRAs, how is that not breaking a contract?

  17. Ron,

    One Roth risk I think you failed to mention is what I think is the most probable scenario of all: the risk of the government shifting its source of revenues from income taxes to consumption taxes.

    Already today there are many political parties interested in a VAT, including but not limited to the environmental lobby. One way to make the VAT politically palatable is to offset the VAT via lower income taxes. Obviously this means income taxes today would in fact be higher than future income taxes (bad #1 for Roths) and moreover, distributions from all classes of retirement accounts would be taxed as they are consumed (bad #2 for Roths). This solution would be a politically savvy way for the government to tax all that juicy Roth money without breaking any explicit promises.

    I do see a million scenarios where you lose money on Roths (including the several you described) but the one I describe above seems most probable.

    Thank you for a wonderful article. People are told over and over by personal finance sources that diversification is everything, but far too few are being told that this wisdom goes for tax structures as much as asset classes.

  18. Alex, I had this in my original draft and ended up cutting it. I shouldn't have and you're right that this is a real possibility.

  19. I'm 51, and have opted for retirement -- have enough, can't make that much more doing what I was doing, had started to hate it ('it' being operating a one-truck moving company, for those who are curious).

    Looking at a Roth conversion, two considerations dominate my thinking. First, 'losses' on the sale of my mother' house mean that I can write off almost all taxable income for the foreseeable future. Second, I think taxes are going to have to go up.

    Therefore, I want to 'pay' taxes now, when the rates are lower. (That the writeoff means that I won't actually pay any taxes anyway doesn't hurt.) So it seems like a no-brainer to me to convert my IRA to a Roth. Plus, assuming I understood the comments correctly, I'll have more flexibility in what to do with that money whenever I reach whatever the age is when I can touch it.

  20. It's taxing the mandatory withdrawal from the regular IRA that is such a problem, as the withdrawal make more of the retiree's social security taxable as well. As many who saved for retirement through IRAs did so because they knew they would need this money eventually, it seems excessively cruel to continue to tax the mandatory withdrawals that they cannot afford to keep in the accounts (as was the case for many this year, despite the year-only respite from withdrawal).

  21. I am only 31, so I don't have a long perspective on the history of revisions to the tax code in this country, but I agree with poster #2 above that "to tax Roths down the road would be a faith-breaking, contract-voiding act that would poison confidence in the US for decades."

    I don't mean to sound naive, but would people really stand for what would boil down to a double-taxation bait and switch if the government tried to change the rules after repeatedly encouraging all of us to save in Roth IRAs?

    I'd like to know if more of you (who aren't government conspiracy fanatics) *really* think there's a good chance of the rules being changed on Roths so as to go back on what has essentially been a government promise.

  22. After the way the Obama administration broke contract and faith with the secured bondholders in the recent auto bankruptcy/UAW rescue packages, I am amazed that anyone would be surprised with your warning.

    In 2005, I cashed out all of our IRA accounts; paid the penalities and taxes, and invested my money where I had the most control -- and that excluded tax-deferred U.S. accounts. Maybe it was just lucky timing, but it was a smart financial decision for us.

  23. I have been skeptical of doing a major conversion next year because I believe tax reform and simplification is in our future. Lets say we end up with some version of the Fair Tax that has been smoldering for a few years. I convert all my funds and pay tax today, and then down the road I have to pay tax once more on my spending. Oh well, at least I can't pull a trigger on this until next year.

    PS: I would vote for a Fair Tax regime because I think that's the only way the black/grey market would be forced to contribute to the cause. Not to mention that we need to eliminate a few thousand loopholes in our current system.

  24. Given that the income figures in the calculation that determines how much of your social security is subject to tax are not indexed for inflation and that half of your gross social security is included in that income, I expect more and more people to be subject to federal income tax on their social security in the future. It is true that keeping IRA distributions out of that calculation might help reduce the taxable portion of one's social security from the current maximum of 85% to 50%.

    I am less concerned about Congress taxing Roth distributions than I am that Congress might move from an income tax to a Value Added Tax. Those of us who are financing our retirement by withdrawing money from regular savings and brokerage accounts have already paid income tax on that money. I am perfectly happy to pay tax on capital gains at whatever rate is in effect at the time; that is, I would be if I had any! But the prospect of a 25-30% sales tax is dreadful.

    I do believe Roth contributions and/or conversions for younger folks are good bets. If you expect to benefit from the proposed health insurance subsidies which are income based, do your Roth conversion in 2010 so your 2011 tax return doesn't have any more income than necessary. If the effective date of the subsidies is 2012, it's possible that 2011 income will be the determining factor.

  25. One big point left out of this article, if the money in your IRA is after tax money and you have not taken a deduction (most likely because you were investing in a 401K at the same time and not eligible for a deduction) then you don't have to pay taxes when you convert to a Roth IRA.

    Please correct me if I'm wrong. The money in our IRAs is after tax money and we are planning to do a convesion next year and don't have plans to pay tax on that money again.

  26. his was a good article. BUT some facts were omitted.

    First, if you convert to a Roth IRA, you are locked in for 5 Years.
    (that's not so good if you need the money.

    Second, The coversion makes great sense if you have the money to pay the taxes.
    If yoiu have a million dollars in an IRA, you can convert the whole thing.
    It's like being able to ADD $400,000. in NEW money to your Roth Ira.
    A million in an IRA less 400,000 in taxes would leave 600,000 in ROTH.
    But, PAYING the taxes leaves you with the full million in the ROTH.

    ALSO, the treasury (IRS) will give you 2 years to pay the taxes. Half in 2010
    half in 2011.

  27. Dear sam #21 Before you convert, check out the 5 year rule. After conversion
    to a Roth, you have to wait 5 years before withdrawing money
    check it out

  28. Any VAT/federal sales tax is likely to be in addition to, not instead of, current federal income taxes.

    There would be a huge debate before tax status of the Roth changes = plenty of time to pull out the money before it becomes taxable.

  29. These kind of discussions make me hope I fall over dead at age 70 like my grandma.

    As in Roger Cohen's meditation on the meaning of life (7/15), one wonders if a longer lifespan is worth the deprivation. Or there's that old joke about dieting doesn't make you live longer, but it sure SEEMS longer. The average US citizen has really taken a slug in the chest over the last several decades. For those of us who missed out on the bubblicious party, we have seen pension plans become a fairy tale even while our 401(k)s fell into negative balances (and MetLife has the GALL to charge "administrative" fees on top of the losses). It is really tough to put aside money for old age when you can barely make it from month to month to live now, especially when one's employment is looking very shaky. An insolvent Social Security seems to have taken a back seat to bailing out Wall Street. As a nation we have a huge wave of retiring boomers who haven't saved or whose assets were wiped out, and we can't just let them die in the streets.

    Your reference to a "crystal ball" is most apt: one needs an otherworldly connection to plan for the future. My generation is looking forward to NO retirement; the quality of our old age depends upon what kind of health insurance plan our Dear Leaders concoct and what kind of genes we have. In my parents' case I see that their frugality and sacrifice means they are required to pay higher taxes and premiums while being ineligible for any kind of assistance.

    Truly the difference between Roth and Regular seems moot. The important thing is to put away $omething even while you know it will be inadequate. Polish up your skills for employment you can carry on into your dotage. Maybe, Mr. Lieberman, in another column you can address jobs for geriatrics, as working oneself to death is apparently our society's default retirement program.

  30. As a financial advisor (CFP R) I see no reason why a planner would suggest not going into a Roth except that the planner works on an assets-under-management basis and doesn't want the accounts lowered with the tax payments.

  31. One way that taxes may be significantly altered is a transition from an income tax base (which hits traditional IRA withdrawals) to a consumption tax base (the VAT is a trendy choice of many economists). The grandfathering of Roth's and TIRA in a tax transition would include a host of tricky issues (e.g. Roth withdrawals not only tax-free but subsidized due to already paying income tax upon contribution or conversion). This tax policy does not directly involve any renigging on tax-free Roth withdrawals.

    Another benefit of Roth's is that they effectively reduce the size of wealthy estates (e.g. $1M TIRA is only a 650K Roth balance). Of course this all depends on what happens to the death tax.

  32. Given the anticipated hyperinflation and devaluation of the USD in 2010 through 2012, would it not make sense to wait for the low in 2012 (while having traditional IRAs in non US denominated assets) to consider converting?

  33. Regarding post #21.

    I have the same question. If my current Traditional IRA was all after tax money because we didn't qualify to take the deduction then if I transfer I won't owe taxes on the principal. However I believe I will owe taxes on the earnings when I convert.

    But...I'm assuming that in 5 months by decimated traditional IRA will not recover from its losses so I'll have no earnings to pay taxes on.

    Sounds like a good deal to me...correct me if I'm wrong on my tax assumptions.

  34. Roth plans came after I retired but I remember a conversation with a friend back in 1973 when he was considering paying the taxes and converting his IRA to cash because he was afraid of what the future held. I wonder how he made out ?
    I have been reading Ed Slott's books. He has lots of good information and ideas . I am considering his newsletter. My problem is finding a person familiar with and capable of implementing his ideas.