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When Roth IRA Conversions Make Sense

By Art Rothschild

Rarely a day goes by this year that I haven’t been asked by a client (or two or three) whether they should convert their traditional IRA to a Roth IRA.  That question has taken on greater importance now that Wisconsin Gov. Jim Doyle has signed into law a bill that allows investors of any income levels to convert their traditional IRAs to Roths without Wisconsin tax penalties.

IRAs, or individual retirement arrangements, are tax-advantaged savings plans that let you provide for your golden years outside of an employer-sponsored retirement program.

If you have taxable income and will be younger than age 70½ at the end of the year, you may contribute to either a traditional IRA or a Roth IRA. Such arrangements can boost your retirement funds by letting investments grow free from taxes along the way.

For more information on IRAs from the Internal Revenue Service, please go to www.irs.gov/taxtopics/tc451.html.

Traditional IRAs give investors tax deductions and an opportunity to have their investments grow tax-deferred until they take distributions in retirement.  All traditional IRA participants are required to take distributions beginning at age 70½ in relatively small amounts over their life expectancies. 

In contrast, participants in Roth IRAs do not get a tax deduction for amounts they deposit in their Roths. Their investments also grow tax-free, but they do not have to begin taking withdrawals during their lifetimes.  After the account owner passes on, though, the beneficiaries of the Roth IRA will be required to take tax-free distributions over their life expectancies.

Generally, I recommend traditional IRAs for those who are in higher tax brackets today and will be in lower tax brackets in retirement – and who are not constrained by the deduction limits on traditional IRAs.  As the saying goes, “A bird in the hand is worth two in the bush.” 

So, for example, someone in a 25% tax bracket who makes a $5,000 deductible contribution to a traditional IRA could receive a $1,250 reduction in their federal tax bill.  In addition to benefiting from the $5,000 contribution growing tax-deferred until retirement, the account holder would have the $1,250 reduction to invest or spend as they deem appropriate. If, in retirement, they have no taxes to pay or are in a lower tax bracket than when they were accumulating, they will be ahead of their peers who put money into Roth IRAs.

For those who, due to income limits, are not permitted to add deductible contributions to traditional IRAs, I strongly recommend Roth IRA contributions up to the maximums allowed each year – currently $5,000 for those under 50 and $6,000 for those 50 and older. 

I also recommend Roths as a multi-purpose vehicle, allowing young investors to accumulate funds for their children’s college educations while retaining earnings in the vehicles for their own retirements.

Investors contemplating conversions, despite the fact that they will have the ability to defer that tax over the next two years, should carefully consider whether the advantages they are seeking are really worth the price they will be paying today. 

Taxpayers have to pay tax today at their current tax rates on the money they take from their traditional IRAs to convert into Roths.  This is particularly disadvantageous if:

  • they do not have the cash outside of their IRAs to pay the tax
  • the conversion will put them in an even higher tax bracket
  • or they will be in a lower tax bracket in retirement. 

I urge anyone considering an IRA conversion to talk with a knowledgeable professional regarding the pros and cons before doing any Roth conversion.

Investors today should carefully weigh the cost as well as the benefit of converting their traditional IRAs to Roth IRAs. 

Despite all the media attention, I find that most investors benefit more from maximizing their annual or monthly contributions to Roth or traditional IRAs than they would from doing a Roth conversion.

Arthur S. Rothschild is a vice president at Landaas & Company. This article was excerpted from Art’s monthly column, “Investment Insights,” which appears in the Racine Journal Times.

initially posted April 29, 2010

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