Should You Convert Your Regular IRA to a Roth IRA?

Tuesday, November 10, 2015

Contributions to a regular IRA are tax deductible and distributions are included in income. Withdrawals prior to age 59 1/2 are subject to a penalty of 10%. Contributions to a Roth on the other hand are not deductible and distributions are not included in income. Roth contributions can be withdrawn without penalties.

However, the earnings in the Roth may be withdrawn without penalties only if the account holder is at least age 59 1/2 years and has held the Roth account for at least 5 years. Minimum distributions from a regular IRA are required when the account holder reaches age 701/2. There are no such requirements with a Roth. For individuals who will not need distributions from their IRA after retirement, this can provide a means of leaving larger IRA accounts to heirs free of income tax. Of course the estate of the account holder will be less because taxes have been paid on the contributions to the Roth. That begs the question, is it better to leave a larger amount to heirs subject to income tax or a smaller amount tax free? The answer to that depends on several factors, particularly the expected tax rate in effect when the heirs have to pay tax on the inherited IRA. And this article will not address issues relative to estate tax.

Taxation of the Conversion

The bad news is that tax must be paid on the amount of the IRA that is converted. This limits the practicality of conversion to individuals who can afford to pay the tax from personal funds. Taking money out of the regular IRA to pay the tax not only reduces the amount of money that will continue to grow tax-free but may result in the imposition of penalties if the individual is less than age 59 1/2.

Who Should Convert?

• Individuals who expect to be in a higher income tax bracket after retirement are good candidates for conversions.
• Young taxpayers with a long time horizon who are in a low income tax bracket should consider converting their IRA accounts. The more time that is available for tax-free growth the greater the argument for conversion.
• Individuals who want to leave money to heirs that is tax free should consider a conversion but we point out again that this does not guarantee more after tax money in your heirs’ pockets.

An important factor to consider in doing a conversion is the average annual return on the IRA’s assets. The higher the rate of return the better the argument for conversion.

Some articles that we have read about Roth conversions describe them as the best thing since sliced bread. We don’t see it that way for the following reasons:

• The payment of taxes today reduces the amount of money available for investing.
• An argument for conversions is that you will save tax if you are in a higher tax bracket when you withdraw funds than you are in today. But predicting what tax rates will be many years in the future is difficult and tax policy changes with every change in administration.
• Few people predicted the recent crash in the stock market which wiped out billions of dollars of portfolio value. Had the investments been in Roth accounts, the owners would have paid tax in prior years on assets that are now worth much less. Can you be certain that this can not happen again before you retire?
• If the beneficiaries of your estate are in a lower tax bracket than yours, you will pay more tax now on the conversion than they will save when they inherit the IRA.

There are calculators available to crunch the numbers and determine if a conversion from a regular IRA to a Roth is appropriate under a given set of circumstances. Several factors are required including a forecast of your income tax rate when you take distributions, when you expect to retire and expected rate of return on your investments. This is a difficult exercise.

For many individuals the best course of action is to have money in both regular and Roth IRA’s. Convert some of your IRA into a Roth but not all of it and do not convert more than you can pay the tax on out of your pocket. This is consistent with advice that we have given to some clients who have 401(k)’s with a Roth option. We have advised most of them to divide their contributions between the regular and Roth 401(k)’s.

Roth IRA’s are smart money moves for some individuals but they are not right for everyone. If you have a regular IRA account, you should discuss with your accountant or personal financial planner whether a conversion of some or all of the account to a Roth IRA is appropriate.