Years ago there was a cigarette ad campaign with the slogan, “I'd rather fight than switch.” Today, some people may feel similarly about their traditional IRA. They want to hold onto it and have no interest in a Roth IRA.
But is it time to convert from a traditional IRA to a Roth?
In a traditional IRA you put the money away without paying tax. You pay tax on the funds when you withdraw them. You are required to start withdrawing your money at age 70 ½. If you leave your traditional IRA to heirs they will have to pay the tax as they withdraw money from the IRA.
However, with a Roth IRA, you pay the tax up front and the money grows tax free and comes out tax free. You aren't under the gun to withdraw at a certain time. “If you're still on the fence, your heirs can receive the Roth IRA assets free of income tax,” says Paul Jacobs, chief investment officer for Palisades Hudson Financial Group.
Does all this have your attention?
The IRS allows everyone to convert a retirement account like an IRA or 401(k) or 401(b) to a Roth IRA at any time. “It doesn't matter how old you are, or how much income you make. You can convert as much as your IRA to a Roth as you want. You can do it all in one year, or do a piece of it each year,” explains Jim Heafner, president of Heafner Financial Solutions.
No matter what your age may be, converting to a Roth may be a smart move from a multi-generational planning angle, says Jerry Korabik, a financial advisor with Savant Capital Management. “Usually, when you have a Roth, that may be the last bucket you tap into during retirement. If you run into a situation where your taxable and tax-deferred accounts last you throughout retirement, a Roth may be a nice way to pass income-tax free assets to your children,” says Korabik.
What you need to know
Like all financial moves, there are key considerations.
Determine your current marginal tax bracket. This is the amount of tax you would pay on the next dollar of income, essentially the tax rate you would pay on the first dollar of an IRA you convert to a Roth. To establish this you must look for your “taxable income” on line 43 of your 1040 form and then compare it to the current tax tables, says David Shucavage, president of Carolina Estate Planners. For instance, a married couple filing jointly will pay 25% on all the “taxable income” between $72,501 and $146,400. See current tax tables to determine your bracket.
Estimate if your future income in retirement will e in this bracket, or a higher one. If your future bracket may be higher, it could make sense to do a Roth conversion now, says Shucavage. Even if you will remain in the same bracket you may want to do a conversion now, if you think tax rates might go up in the future. You basically lock in today's tax rate. If your future tax rate will be lower, a conversion may not make sense – you would pay less tax in the future.
One big mistake people make is that they convert an entire IRA at once which may put them in a higher marginal tax bracket. A better strategy, says Shucavage, may be to convert only enough of the IRA to “max out” your current bracket. For instance, if married couple filing jointly is in the 225% bracket and their current taxable income was $100,000, they would only convert $46,400 of their IRA this year, keeping the tax on the conversion in the 25% bracket. Doing more would mean the excess was taxed at 28%. Next year they could convert more of the IRA.
Be sure to have the money set aside to pay for taxes that result from a Roth conversion. “The money should come out of bank account savings, current cash flow or home equity. Don't take the tax money out of your investments or long-term savings,” says Larry Rosenthal, an ING retirement coach.
The conversion amount will be included in income to determine the phase out on itemized deductions and personal exemptions. The conversion amount can make social security taxable, and while the conversion amount is not subject to the 3.8% surcharge, it may make the taxpayer's other income subject to the 3.8% surcharge, says Northeastern University professor Timothy Gagnon. Conversion may make the Medicare Part B premiums higher for the following year, which is based on the recipient's taxable income fro the current year. Conversion can be complex, you certainly want to talk to your accountant before making any moves.
Realize too, that money in a Roth IRA has to incubate until you are age 59 ½ in order to take advantage of its tax advantages.
You can do a “do over”
If you change your mind once you convert you can do a “do over.” There is flexibility in the conversion. “You have the ability to do a 'do over' , also known as a re-characterization without incurring any negative tax consequences,” says Bradley Bofford, managing partner, Financial Principles. Why might you want to back track? Say you converted to a Roth in October 2013 and the market value decreases thereafter, you can choose to re-characterize the Roth conversion. It can be put back into the traditional IRA or you can even do another Roth conversion off the lesser amount. You have until October 15th of the year following the conversion to do the re-characterization.
Two huge reasons to switch
Along with tax-free withdrawals, a big advantage of a Roth is that there are no required minimum distributions. “The chief complaint I hear from those who saved properly for retirement is, 'I did what I was supposed to do and sacrificed all of my life, now I feel like I am being penalized for doing what I was supposed to do,.'” says Leonard Wright, co-host of the radio show Financial Fridays. Not only may the saver be forced to take out money they really don't need, but having to tap money at age 70 ½ can result in the saver having to pay taxes in a higher tax bracket, points out Wright. There are no such worries with a Roth.