To Convert Or Not To Convert
In 2010, holders of traditional IRAs, regardless of income levels, may convert them to Roth IRAs. Despite the benefits of a Roth, including tax-free withdrawals and no mandatory withdrawal requirements, conversion may not make sense for many investors.
Investors must pay taxes on the amount converted, though any contributions made from after-tax dollars are exempted. Conversion can create a sizable tax hit, depending on your income-tax bracket and the size of the traditional IRA being converted.
Investors who convert to a Roth IRA in 2010 have the ability to defer taxes owed on the conversion until tax years 2011 and 2012. However, whether to defer the taxes or pay them in 2010 may depend on your expected income and expected income-tax rates in 2011 and 2012.
To determine whether conversion makes sense for you, answer the following questions:
How will you pay the taxes? It is very difficult to justify conversion if you plan to use proceeds from the IRA you are converting to pay the taxes.
What’s your age? The more years you have to accumulate tax-free earnings — and the more years you have to make up for the lost returns on the funds used to pay the income taxes — the more attractive conversion becomes.
Where do you see your tax rates in the future? Calculating whether to convert requires making a number of assumptions, not the least of which is your expected future tax bracket. If you think your tax rates will decline in the future, it probably does not make sense to convert.
How important are the estate-planning benefits of a Roth? For some investors, the ability to leave their heirs an income-tax-free Roth IRA is a powerful driver for converting to a Roth.
Finally, conversion requires a leap of faith that Congress will never tax Roth IRA assets. If you aren’t willing to make this leap, don’t convert your traditional IRA to a Roth.