By FPA Member William Z. Suplee IV, CFP®, CFA, ChFC, CASL, AIF
Last Updated: March 14, 2011
Since the beginning of 2010, anyone can convert a traditional Individual Retirement Account (IRA) to a Roth IRA regardless of income. However, the ability to spread the taxes over a two-year period that was available in 2010 is no longer an option. The removal of income limits does not apply for contributions to a Roth in 2011, only for the conversion of existing IRAs into a Roth IRA.
Before you proceed with a Roth conversion, there are some important factors that you should consider.
Pay your taxes from outside sources: Generally if you're considering a Roth conversion you should pay the taxes from monies outside of the existing IRA. In order to defer future taxes, you need to pay the taxes up front. If you will need to use money from the IRA to pay the taxes today, you may nullify or reduce much of the benefits of the Roth conversion.
The Roth conversion is a trade-off between current tax rates and future tax rates. If you expect your future tax rates to be the same, or higher, than they currently are, the conversion might make sense. If you expect future tax rates to be substantially lower, you might want to get professional advice before you do any conversion.
Know your holding period: If you expect to withdraw the money within the next five years, you probably don't want to do this conversion. The longer the period you have for tax free compounding, the more attractive Roth conversions become. Roth conversions are particularly attractive for individuals who intend to pass these assets onto their heirs or have a long time before they expect to make withdrawals from the Roth. Unless you're 59 1/2 years old, or have held your assets in your Roth for at least five years, distributions might be subject to a 10 percent penalty.
Consider tax diversification: The Roth conversion does not have to be an all or nothing proposition. It might make sense to do a partial conversion. While the existing IRA rules make the conversion to a Roth very appealing for certain taxpayers, we don't know what the future will hold. If, in the future, the rules are changed regarding Roth distributions, like requiring a minimum distribution, it will adversely affect the calculated benefits of conversions. This will be particularly true for Roth's intended to be used as an estate planning vehicle. One way to protect against this is to diversify across your tax categories. Partial Roth conversions, rather than total conversions, are one way to arbitrage any future tax changes.
FPA Member William Z. Suplee IV, CFP®, CFA, ChFC, CASL, AIF, is President of Structured Asset Management, INC. and Treasurer for FPA of the Philadelphia Tri-State.