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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 jointly.

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Calculation considerations
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 the longer-term.

"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 tax bracket.

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:

  • Eligibility
    Traditional: You have earned income and you won't reach age 70 ½ by the end of the year.
    Roth: 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.

  • Contributions
    For both traditional and Roth you may contribute up to $3,000 of earned income in a tax year ($6,000 for married couples.)
    Traditional IRA contributions are generally tax-deferred if you don't participate in an employer-sponsored retirement plan.
    Roth IRA contributions are never tax-deductible; they come from after-tax money.

  • Distributions
    Traditional: 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 ½.
    Roth: 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 years.

-- Posted: Sept. 18, 2002

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See Also
The right way to pick mutual funds
What in the world is an IRA?
Put some real estate in your IRA
Investing glossary
More investing stories

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