Roth IRA Conversion Has Its Benefits, but Deciding Is Tricky
Financial services companies are using a temporary change in Roth IRA conversion rules to roll out a marketing juggernaut to convince you that conversion is the greatest opportunity ever. Coincidentally, they also hope to convince you to use their services.
Temporarily next year anyone can convert a traditional IRA to a Roth, regardless of income. Currently only those with incomes of less than $100,000 can make the switch.
Is a Roth conversion a wonderful opportunity? Maybe for some retirement account holders, but certainly not for everyone. The decision to convert is also very complicated and needs to take into account an individual’s taxes, estate planning, retirement income needs, and predictions of future tax rates.
Immediate Tax Bite
Marketers are touting all the advantages of a Roth IRA: tax-free growth and withdrawals, tax free inheritance, and no required distributions after age 70.5. But they don’t emphasize the immediate tax hit, which discourages many IRA conversions.
The owner of a $250,000 IRA who is in the 25 percent federal tax bracket and a 6 percent state tax bracket, for instance, would have to pay $77,500 in additional taxes to convert. And that money cannot come from the IRA: it has to come from another source, such as a bank or broker account.
Estate Benefits
Some conversion benefits only apply to the rich. Those who are leaving behind millions of dollars and worried about estate taxes might do better converting now and paying state and federal income taxes, because the state income tax is deductible for federal tax purposes.
Leaving the money behind in a taxable IRA instead would cost more, because there is no deduction for state estate taxes after death.
Also, high income taxpayers who have big income tax deductions that they can’t take in 2010 would benefit by creating taxable income through a conversion, allowing them to use the deductions.
IRA owners who do not plan to spend any of their IRAs in retirement may also want to convert to a Roth in order to avoid required distributions at age 70.5 and so that heirs get their IRAs tax free.