A Roth conversion of an existing retirement account is a major decision. Among other factors, you must consider your current income tax rate, your expected future income tax rate, and the anticipated rate of return of your investments. But before you take the time to determine whether converting to a Roth IRA is right for you, make sure you’re eligible to convert in the first place. Like many other retirement plan decisions, it helps to get all your information together in one place.
What is a Roth Conversion?
A Roth conversion is an optional decision to change an existing qualified retirement plan, such as a 401(k) or a traditional IRA, to a Roth IRA. By doing so, you take money that is currently treated as tax-deferred and convert it into an account which grows tax-free. In order to make such a conversion, however, you must pay taxes on the amount you convert.
Who May Convert to a Roth?
To be eligible to convert a tax-deferred retirement account to a Roth IRA, your modified adjusted gross income (MAGI) must be less than $100,000. In addition, your filing status must not be married, filing separately. Note that this $100,000 limit does not include any income from your decision to convert to a Roth. For example, if you are a single individual who has an MAGI of $90,000, you may convert an unlimited amount of tax-deferred money into a Roth IRA; you’re not limited to the $10,000 difference between $90,000 and $100,000.
Note: Current tax laws provide for the removal of the $100,000 income restriction beginning with the year 2010.
Making the Decision About a Roth Conversion
Converting often makes sense if :
- you believe that the benefit from your money growing tax-free will be greater than the cost of having to pay the taxes due on conversion
- you have the money available to pay the taxes due on conversion
Like any analysis, a calculator’s results are only as accurate as the assumptions you provide it. Keep in mind the following when making your decision about converting to a Roth:
- If you expect your tax rate to be higher in retirement than it is right now, a conversion is more likely to be the right move.
- The greater the expected rate of return of your investments, the more likely a Roth conversion is a good idea.
- The longer you have until retirement (and, therefore, until you will need to take your money out of the Roth IRA in order to support yourself), the better the Roth conversion will appear.
Previous Non-Deductible Contributions and a Roth Conversion
If you previously made non-deductible contributions to your IRA or 401(k), then part of the amount you convert to a Roth IRA will not be subject to tax. Unfortunately, you can’t just take out the non-taxable portion. Instead, the government requires that every dollar you convert be split between non-taxable and taxable based on the ratio the non-deductible contributions represent of the value of your retirement accounts. For example, if you previously made non-deductible contributions to your IRA of $8,000, the value of all of your traditional IRAs is $80,000, and you decide to convert $10,000, then 10% ($8,000 out of $80,000) of your conversion, or $1,000 ($10,000 x 10% = $1,000) is not taxed. You would pay tax on the remaining $9,000 conversion.
Accounts You May Convert to a Roth IRA
If you are eligible, you can convert a traditional IRA or a 401(k) to a Roth IRA. Note, however, that you typically cannot convert a 401(k) to a Roth IRA while you are still working for the employer where your 401(k) is held. However, when you terminate employment, you may convert and rollover your IRA at the same time.
All or None?
Many people cannot afford to pay the taxes due on a potential Roth IRA conversion. Unfortunately, although some of these people feel conversion is their best long-term financial strategy, they don't feel they can actually take advantage. If that sounds like you, there may be another answer: convert only the amount of your account on which you know you can comfortably afford to pay the tax. As long as you continue to be eligible to convert, you can continue to do a partial conversion year after year, never having to make that giant tax payment, yet gradually converting your retirement accounts to tax-free status.