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Should You Switch From a Traditional IRA to a Roth IRA?

Should You Switch From a Traditional IRA to a Roth IRA?

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.

Avoid mistakes

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.

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Kennewickman   |     |   Comment #1
When you convert to a Roth the funds must season for 5 (tax) years (no withdrawls) even if over 59 1/2. Example- if  you converted on December 31, 2010, funds could be withdrawn without penalty as early as January 1, 2015. This is 5 (tax) years even though funds were actually held for 4 years and 1 day. 
wrennmike   |     |   Comment #2
Once again, the arguable party-line strategy that urges depleting resources now to reap future financial benefits that rely on both a substantially unchanged tax code and no significant revisions to Roth IRA rules for decades.
Ally   |     |   Comment #3
We had Roth IRA's since they started in 1998 and had a Roth 401K offered for the last year I worked. We have been converting some to a Roth for the last 4 years, using money outside of our IRA's to pay taxes on it while keeping in the same tax bracket. With all the talk of the BIG TAX deal and one of the suggestions is singles on Medicare will be paying higher Medicare premiums at $47,000 income so converting to keep RMD's lower could be a tax decision also. It would be double that for couples. But remember the $85,000 and $170,000 that we have now is fixed until a large portion of seniors have that much income. As RMD's get larger, we earn more interest on CD's and SS payments increase it may not take too many years to get that much income and many will be in that range if it is changed to $47,000 and $94,000 in a few years. With a Roth you will have more of a choice  if you take it out and it is not now counted in the MAGI and another consideration is if you don't use it the kids get it tax free. One of the tax suggestions in the BIG DEAL is once the IRA's are inherited that the beneficiaries would have to take it all out within 5 years. 
gcomfort   |     |   Comment #4
The comment by Kennewickman is basically correct, but I believe a slight clarification is in order.  The five years is measured from when one started his first Roth IRA.  So, even if you are not ready to convert a large amount of TIRA to Roth, it might be worthwhile to open a small Roth now so that the claock will start.
Ally   |     |   Comment #5
Is there a separate 5 year waiting period for the Roth IRA and the Roth IRA conversion?