Roth IRA: To Convert or Not to Convert

In 2010, anybody will be able to convert funds from a traditional IRA to a Roth IRA, since the $100,000 MAGI (modified adjusted gross income) restriction is eliminated. Given the opportunity, the question is whether is it makes financial sense to do a conversion or not. In most cases, I don't believe there is a standard answer that works for everybody. Each case needs to be considered individually. Here are the criteria we used, when we became eligible to do Roth conversions.

Current tax rate lower than future tax rate. A key question is whether the tax rate on the conversion or the tax rate on the future IRA withdrawal will be higher. If the future tax rate is projected to be higher, a conversion made sense to us. If the future tax rate is projected to be lower, then not doing a conversion would make sense.

Of course, we are not able to estimate future tax rates with 100% certainty. However, I believe, with 100% conviction, that our marginal tax rate will be higher than 15%. If we are able to make Roth conversions at a 15% tax rate, I believe we will be better off financially than leaving the funds in a traditional IRA. Therefore, we have been doing Roth conversions only if our taxable income is at a 15% marginal tax rate.

To me, it is a tougher decision at a 25% marginal tax rate. However, I still believe that my future marginal tax rate will likely be at 25% or higher.

Amount of funds subject to the required minimum distribution (RMD). The RMD is the amount of funds an IRA owner is required to withdrawal each year after reaching the age of 70 1/2. An RMD must be taken, even if the recipient does not need the funds. Thus, RMD reduce the capability of the IRA owner to manage his income for tax purposes. The larger the amount of funds in traditional IRAs, the more it may make sense to do a Roth conversion.

Since my company's retirement funds were in a profit sharing plan (i.e. similar to a 401(k)), we will eventually have a large amount of savings in traditional IRAs as funds are rolled over with time.

Having funds outside the IRA to pay the tax. If all of the IRA funds are converted to a Roth IRA, the taxpayer will only owe taxes on the amount converted. If part of the IRA funds are used to pay the taxes, a 10% early withdrawal penalty will be assessed on the amount if one is under the age of 59 1/2.

We were able to pay all the taxes with funds from our taxable accounts.

Since the answer to each criteria was a "yes" for us, we proceeded with doing Roth conversions in 2008 and 2009. For our Roth conversion decision in 2010, we will apply the same criteria again.

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This is not financial, IRA, or tax advice. Please consult a professional advisor.

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