Step 3: Weigh financial and tax factors
For many taxpayers, the decision to convert is highly individual. How old you are and your present tax bracket all factor in.
"An important factor in deciding whether to convert is considering how much time you have before you retire and will potentially need to use the money," Ciocia says.
The higher your tax bracket, the more tax you will have to pay on conversion. But if you expect taxes to go up in the long term, conversion makes sense because you may have to pay a higher tax rate in retirement than you expect now, Ciocia says. If you convert, you'll have a tax-free source of retirement income along with any taxable source of income, such as a traditional IRA, 401(k) or 403(b).
As Ciocia puts it, "Would you rather pay taxes when you plant the seeds or harvest the crop?" In other words, you likely would pay less in taxes on a $5,000 Roth IRA contribution than you would if you had left the money in a traditional IRA and it grew to $34,242 after 25 years of tax-free growth at 8 percent.
In that example, even at a low 15 percent tax rate, your taxes would be $5,136.30 if you left the money in a traditional IRA -- far higher than what you will pay now on a $5,000 conversion to a Roth.
Step 4: Calculate the potential tax due
Figuring out the tax due on conversion is not that complicated. Basically, you owe federal and state taxes on your contributions and any gains, meaning the entire value of your IRA, unless you made nondeductible contributions. If you made nondeductible contributions, you would subtract those from your current total IRA account balances to come up with the amount that will be taxed.
Here's an example:
|Current value IRA account:||$50,000|
|Nondeductible IRA contributions:||-$10,000|
|Total taxable value:||$40,000|
|Times the current federal tax rate||x 0.25|
|And the current state tax rate|| x 0.05|
|Tax bill for conversion||$12,000|
You'll still get a break when you pay your taxes. Using the above example, with $12,000 in federal taxes due, you wouldn't have to pay any of that in 2010; you'll owe $6,000 in 2011 and another $6,000 in 2012.
Step 5: Decide when to pay the tax bill
There are a few other issues to consider when deciding whether to pay the tax due immediately after conversion -- if you can afford to -- or defer it.
"Whether you want to pay the taxes in 2010 or spread it out over the next two years depends on how consistent your tax situation is," Sadler says. "If you're a W-2 employee and don't have any capital gains or other types of holdings that might create surprises along the way, ... you aren't likely to see a huge tax increase. So I would think deferring those taxes over a two-year period would make sense."