Why You Should Convert Your Traditional IRA to a Roth

In 2010. Or not.

I recently wrote a post on how to choose between the two kinds of IRA, traditional and Roth. In a nutshell, the big deciding factor is the tax rate you are paying now versus what you will pay when retired. If you are paying a higher rate now, go traditional. If you will pay a higher rate when retired, then Roth is for you.

The core difference between the IRA types is deceptively simple. With a traditional, you don’t pay taxes on money you put in, but do pay taxes on the way out. A Roth is the other way around, the money that goes in is after-tax, but the money that comes out is tax free. But like that old bit about the butterfly’s wings causing a storm, this clear difference between IRA types propagates into uncountable obscure details.bouncy castle sales

One of those dark corners of the IRA world is the option to convert an existing traditional IRA into a Roth, which involves paying income taxes on the amount converted. (And no, there is no such thing as a conversion in the other direction that would cause a big tax refund.)

Currently, and until next year, you cannot convert if you have an income over $100K. Not only does that rule go away next January, but there is a special 2010-only deal: you can delay the taxes due and spread them out over two years, 2011 and 2012, which is an interest-free loan from Uncle Sam. (In any other year, it would be all due in the year in which you convert.)

Is this a good idea for you? Two things need to be true. First and foremost, you need to be pretty sure that your income tax rate in 2011 and 2012 will be lower than the tax rate you pay in retirement. This is the usual traditional vs. Roth question, made a little harder because you need to guess your tax rate in a few years from now as well as your tax rate in retirement.

Second, you need to be able to come up with the money to pay the taxes. A reasonable person might think that you could use some of the money from the traditional IRA to pay the the taxes on it. Alas, no, everything must go directly from one IRA to the other. Any money taken out to pay taxes (or for any other reason) before retirement age gets taxed as income and gets hit by an additional 10% penalty.

On the other hand, the fact that you transfer the whole amount from the traditional into the Roth and pay the taxes with other money means that when you’re done the IRA is worth more. $100K in a traditional is worth less than $100K to you, since you will need to pay taxes on it when you take it out. But $100K in a Roth is really worth $100K.

Some Bad Reasons to Convert

This isn’t a topic that has been covered that well in the blogosphere, but run a Google search and you will find some pretty goofy arguments for and occasionally against conversion. Several bloggers (e.g. this one, this one, and this one) suggest that now is a great time to convert because the value of your account is probably down a lot, the implication being that this condition is temporary and you’ll be kicking yourself when the markets snap back. Sorry to be a wet blanket, but there’s no reason to assume markets will roar back soon. (Actually, I’m not at all sorry. See my posts here and here for more dismal truth on this.)

A surprising number of professional commentators are lost on this topic. Philip Moeller at US News & World Report gets the years for the 2010 deferral wrong and shares the cluelessness of Christina Benz at Morningstar who thinks that “the younger you are, the more beneficial a conversion will be. That’s because you’ll have more years to recoup the tax hit.” That’s just nonsense. If you assume the tax rates are constant, there is no tax hit, it’s a perfect wash. You can pay X% now or later and you end up with the same after-tax amount. Morningstar also provides an IRA Calculator, that for the life of me I cannot make heads or tails of. I’ve sent Benz an email (no comments allowed on her site) asking for clarification, so perhaps she’ll write back and I will correct this later.

Some Good Reasons to Convert

The best reason to convert is that you believe that you will be paying a lower, or at worst equal, tax rate now as compared to when you take the money out of the account in retirement. If this is not the case it is very unlikely that this will make sense for you. Period.

Even if you think that the tax rates might be the same, there are some nice things about converting to a Roth. As mentioned above, after the conversion you wind up with an account worth more to you, even though the dollar amount is identical. Think of this as a sneaky way to get more money into a tax advantaged account. Indeed, converting to a Roth from a traditional may be the only way you can get money into a Roth. Although the maximum income restriction on conversions goes away next year, the income limits on contributions stay. And Roths, unlike traditionals, have no forced withdrawals after age 70 1/2.

Yet another wrinkle and advantage of converting is the option you have to undo it if you think better of the whole thing before you file your next tax return. This could turn out to be a profitable option. Let’s say you convert in January 2010 when your account has $100K in it. By October, the markets have sunk and the account is worth only $85K. You can then invoke what we used to call in stickball a “do over” and what I am told golfers call a “mulligan”, wait 30 days, and convert all over again. The point? You pay taxes on $85K not $100K.

Of course, all of this, particularly the special 2010 rules, presumes that our leaders in Washington don’t change the rules in the meantime. Anything is possible, and there are those who think the Roth is in trouble with a Democratic Congress and White House. (Roth was a Republican Senator.) I would never make assumptions about what will happen in Washington, but I am not that worried. Although Roth and Roth conversions may result in less tax revenue over the long run, they generate more revenue in the short run, and that’s what politicians care about.

Investing | Frank Curmudgeon | March 2, 2009 6:16 pm

242 Comments

By SJ, March 2, 2009 @ 8:55 pm

Pretty interesting… while I’ve always know about the conversion, I had a question.

When converting from a Trad. to a Roth IRA, I am assuming the conversion does not go against your contribution limit for the year?

What about doing the same from a 401k to a trad ira?
By Frank Curmudgeon, March 3, 2009 @ 8:34 am

You are correct, conversions don’t count as contributions. Indeed, there are cases when you can convert but are not permitted to contribute.
By Mas, March 9, 2009 @ 5:43 pm

In 2010, can you contribute to your non-deductible traditional IRA for 2010 before making the conversion to your Roth? (i.e. getting another year’s worth of contributions to convert?)
By Frank Curmudgeon, March 9, 2009 @ 6:41 pm

As the rules are currently written, you can make non-deductible contributions to a traditional IRA and then convert that over to a Roth in 2010. As far as I can tell from reading IRS pub 590 you can contribute and convert on the same day if you like.

For those of you who don’t immediately see what Mas is getting at, for now, there is a huge loophole in the IRA rules that I think nobody really thought about years back when this 2010 thing was dreamt up. There are no income limits on making non-deductible traditional IRA contributions. Starting in 2010 there will be no income limits on converting traditional to Roth. So as long as you are willing to do some paperwork, there will be no practical income limits on contributing to a Roth. I think there is a good chance this will be “fixed” by 2010, but you never know….
By joewatch, April 30, 2010 @ 2:12 pm

Dear Frank,
Regarding Ms. Benz statement, “the younger you are, the more beneficial a conversion will be. That’s because you’ll have more years to recoup the tax hit,” she’s correct. I have done the calculation, and you can be better off converting a traditional to a Roth IRA even if your tax rates are lower in retirement, given reasonable returns on investment.

As an example, imagine this simple scenario. Your traditional IRA is worth $100,000. You pay a 40% income tax rate (federal + state income tax). You only have 1 investment option, a simplified zero coupon bonds paying 5% that you only pay taxes on at maturity. You have 20 years until retirement, when you are forced to take a 100% distribution if you have a traditional IRA.
Therefore, your options are:
Option A – $100,000 in a traditional IRA + $40,000 in a taxable account, or
Option B – $100,000 in a roth IRA + $0 in a taxable account since you used the money to pay the taxes on the conversion.

How much do you have at the end of 20 years?
Option A – $159,198 + $79,679 = $238,877
Option B – $265,329

In this scenario, the Roth IRA wins by $26,452, or 11%. The difference is tax-free compounding, you are even better off if you have more years before you need to take withdrawals.

I think you owe Ms. Benz an apology!

joewatch