Roth IRA Conversions and You: A Primer

Roth IRA Conversions and You: A Primer

David Marotta over at Forbes asks a question that was beaten into the ground in 2010 and 2011, but in light of President Obama’s recent tax proposals, bears repeating in 2012. Have you considered converting your traditional IRA into a Roth IRA? Because contributions to a traditional IRA are generally tax-deductible, they are subject to income tax on the other end of their life cycle, i.e., upon distribution. If you’re years from retirement, it’s impossible to predict what tax rate you’ll be paying when distributions are received from the IRA, but you wouldn’t be foolish to suspect that our current tax rates may be the lowest we’ll see for a long, long time. If that’s the case, you may well benefit from converting your traditional IRA into a Roth IRA during 2012. [i] The tax implications of a Roth IRA are the polar opposite of its traditional cousin; contributions are not deductible from taxable income, but the subsequent growth and distribution of the contributed funds are free from income tax. In addition, unlike traditional IRAs , which require owners to start taking distributions at age 70 ½ , no such requirement for distributions exist for Roth IRAs. If one could convert a traditional IRA to a Roth IRA without generating taxable income, one could enjoy the best of both retirement plans. The contribution to the traditional IRA would have been deducted from taxable income, and the subsequent distribution would be tax-free. For this very reason, upon the conversion of a traditional IRA into a Roth IRA, a taxpayer must recognize taxable income to the extent of the converted balance (assuming all of the contributions to the traditional IRA were tax deductible). If President Obama is re-elected, he is promising to increase the top tax rates from 33/35% to 36/39.6% starting January 1, 2013. So for wealthy taxpayers, 2012 may represent the last chance to take advantage of a Roth IRA conversion while saving 3-4.6% in federal income tax. Of course, there is an element of risk involved, as by converting your traditional IRA to a Roth IRA you’re voluntarily accelerating taxable income because you’re gambling that tax rates will increase in the near future (thus making this the right time to do the conversion). These conversions are not without potential with misstep, making proper guidance a must. You’re best served talking to someone who knows what he’s doing, like WS+B Partner Hal Terr, who’s consulted on several dozen conversions in the past three years. He’s even gone ahead and created this extremely helpful decision tree (PDF version), which can be used to determine if you are in fact a candidate for conversion. Below is a JPEG of the decision tree. Click to enlarge