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8 questions before a Roth IRA conversion

Don Taylorq_v2.gifDear Dr. Don,
I am 69 years old and have a traditional individual retirement account, or IRA, containing about $570,000. I am not in debt and currently use about $3,500 a month from the IRA for living expenses. Through stock trading, my IRA account balance continues to grow. Should I consider a Roth IRA conversion? Does it make sense to convert all or part of my traditional IRA to a Roth IRA?
-- Clyde Convert

a_v2.gifDear Clyde,
At your age, the decision to convert to a Roth IRA from a traditional IRA isn't clear-cut. You want to look at your total financial picture as well as the goals for this money. An advantage of converting all or part of the account in the 2010 tax year is that you can choose to defer the taxes due into the 2011 and 2012 tax years. Spreading the tax hit can save you money.

Another reason to consider the conversion is to get out from under the required minimum distribution of the traditional IRA. You're currently drawing down $42,000 a year but managing to keep the account balance from shrinking by trading the account and earning a higher rate of return than your withdrawal rate. So minimizing your RMD isn't likely to be an issue.

Other things to consider:

  • How will you pay the taxes? Do you have money available from outside of the traditional IRA to pay the taxes due? If so, a conversion might make sense because you're not using the tax-deferred account to pay the taxes.
  • What's the nature of contributions? Were any of the contributions to the traditional IRA made with after-tax dollars? If so, this makes conversion less expensive because you already paid income taxes on some of the contributions.
  • Where are future tax rates heading? If you expect your marginal tax rate to go up in the future, converting now can save money.
  • Are you subject to the alternative minimum tax, or AMT? Being subject to the AMT can make it more expensive to convert.
  • Are you planning charitable contributions? Plan on donating part of your account balance to charity? If so, it doesn't make sense to pay taxes on the conversion only to donate the money to charity.
  • How does the five-year conversion rule impact you? Since you're older than age 59½, there's no penalty tax on early distributions out of the Roth IRA. Also, since you're funding the account on conversion, you shouldn't have an issue with taxes due on earnings out of the account prior to satisfying the five-year rule. See IRS Publication 590's Figure 2-1 to see a flowchart that answers the question, "Is the Distribution from your Roth IRA a Qualified Distribution?"
  • What's the impact of conversion on Social Security benefits? The increase in income resulting from a Roth IRA conversion can increase the income taxes due on Social Security benefits in the year of conversion. Subsequent distributions from the Roth won't influence the taxation of your Social Security benefits.
  • Is a partial conversion an option? A partial conversion can reduce the size of your traditional IRA. This can in turn reduce the required minimum distributions. However, you're already drawing down at a healthy clip -- $42,000 a year -- so this probably isn't an issue for you.

You can input your particulars and outlook into Bankrate's "Convert IRA to Roth calculator" and evaluate what makes sense. Alternately, you can use one of the work sheets on the various brokerage Web sites.

Still can't decide? Talk to your tax professional.

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