Time is ripe for a Roth conversion
When the stock market reaches stomach-churning
lows, there's a good chance your IRA is making you reach for the
antacids, too. It may be time to convert your traditional IRA into
a Roth IRA.
If your traditional IRA was worth $40,000 last year
and today it's worth $25,000, you'll pay $7,000 in taxes now (at
the 28-percent rate) as opposed to an $11,200 tax bill if you converted
when your IRA was at $40,000.
The main benefit of a Roth is that the contributions
and their earnings grow tax-free for the rest of your life -- and
the life of your heir, should you pass it on to someone. The drawback
is you have to pay income taxes next year on the conversion. The
conversion has to be done by Dec. 31; the tax is due April 15 of
the following year.
Qualifying is just one of the things to consider.
Converting to a Roth isn't for everyone.
Whether single or married, your household adjusted
gross income must be under $100,000 to convert a traditional IRA
to a Roth. Married people who want to convert to a Roth must file
You'll also have to determine whether the traditional IRA, with
its tax-deferred status, is better for you than the Roth. This takes
a bit of projecting: your tax rate now vs. what you expect it to
be when you retire.
If you think you'll be at a significantly lower rate
in retirement, you may be better off sticking with the traditional
IRA and paying taxes when you make withdrawals.
Certified financial planner James Knaus of LaBrecque,
Price & Roehl in Troy, Mich., says that may apply to a lot of
people when they retire.
"The problem is you're dealing with a bunch of
unknowns. Nobody knows what the tax laws and rates will be like,
but based on new changes, we now have a 10-percent rate and a 15-percent
rate and a lot of people won't hit the 25-percent rate in retirement."
Use your favorite search engine to find a Roth IRA
conversion analyzer. It will make the calculations that can help
you decide whether the Roth is for you. We found the Strong
calculator to be very user-friendly.
Generally, you'll want to convert to a Roth if the
contributions to your traditional IRA are nondeductible. That may
be the case if you have a rollover IRA and are now participating
in a company-sponsored 401(k).
In almost any scenario, a conversion is probably a
smart move if you're more than 12 years from retirement. Jason Flurry,
a certified financial planner and president of Legacy Partners Financial
Group, Woodstock, Ga., says the Roth often comes out ahead over
"In most comparisons of the traditional IRA and
the Roth, with compounding, they pull away from each other about
10 to 12 years out."
Pay less with partial conversion
But a key factor in that is paying the conversion taxes with money
that's outside of the IRA.
"It doesn't make sense if you don't have money
in another pocket to pay the taxes on the conversion," says
CFP Chris Cooper of Toledo, Ohio. "That defeats the conversion
to the Roth. You want to shove as much as possible into the Roth
to earn investment returns on as large a principal as possible."
You'll also want to be careful if the conversion adds
so much money to your income for the year that you get kicked up
into a higher tax bracket.
But thanks to an interesting feature of the Roth,
there's a way to avoid a big tax bite or getting pushed into a higher
You don't have to convert your entire IRA at one time.
If you have even one stock or mutual fund that is especially low-priced
right now, you can convert just that stock or fund.
A partial conversion means a lower tax bill, so if
you want to convert your traditional IRA but are holding off because
you can't afford the tax on the entire portfolio, cherry-pick a
few stocks or funds.
Next year you can pick a few more. Converting this
way should also keep you in the same tax bracket unless your other
income brings you right to the borderline.
Reneging a Roth conversion
Converting to a Roth can be a mistake-proof proposition, thanks
to something called recharacterization.
If you convert to a Roth and the value of the portfolio
drops, you can recharacterize, change your Roth back into a traditional
IRA, so you won't have to pay tax on the Roth valuation. If you
already paid the taxes, you can file an amended return and get a
credit. You have six months from the time the tax is due to make
a decision about recharacterizing.
You still have the option of reconverting back to
a Roth again, but you can't do it in the same tax year and you must
wait at least 30 days if you do it in December.
"If I convert my Roth in July, and it's worth
$90,000 and then at the end of December it's worth $80,000, I can
convert back to a regular IRA and then wait until January or at
least 30 days later and reconvert again to a Roth and pay taxes
on the smaller portfolio value," says Chris Cooper.
Here are some of the differences between the traditional
IRA and a Roth IRA:
You have earned income and you won't
reach age 70 ½ by the end of the year.
You have earned income and your modified adjusted gross income
is $95,000 or less for single taxpayers, $150,000 or less for
married filing jointly.
For both traditional and Roth you may contribute
up to $3,000 of earned income in a tax year ($6,000 for married
IRA contributions are generally tax-deferred if you don't participate
in an employer-sponsored retirement plan.
IRA contributions are never tax-deductible; they come from after-tax
Distributions taken after age 59
½ are taxed as ordinary income. Distributions taken before
59 ½ are generally also assessed a 10 percent early withdrawal
penalty. You must begin taking minimum required distributions
by April 1 of the year after the year in which you reach age 70
You never have to take distributions
from your Roth. But you can begin taking them tax and penalty-free
at age 59 ½ as long as the account has been open for five
-- Posted: Sept. 18, 2002