The big news in retirement planning is the ability to convert a Traditional IRA to a Roth IRA in 2010, and paying the taxes on your investment now, rather than in the future at possibly higher tax rates.
While this may be a good strategy for some, the most important thing to do is to run your numbers. You have to know what you will owe in taxes and at what point will you break even.
For example, let’s look at a Traditional IRA portfolio with comingled pre- and post-tax contributions. The total IRA is worth $100,000 with $10,000 in post-tax contributions. You would be able to convert 10% tax free. While this example is with easy, round numbers, the IRS allows you only to convert a percentage of your total portfolio tax free, based on the percentage of post-tax contributions relative to your total contributions.
Reporting this is very easy to do: On line 15a of your Form 1040, you report your entire conversion of $100,000 and on line 15b, you enter $90,000, the amount that you need to pay tax on.
The next question, should you do the conversion? First and foremost, you need to determine your breakeven point. You need the liquidity outside of your IRA to pay the taxes due. If you are converting $100,000 you need to have between $30,000 and $41,000 to pay the taxes. Assuming your Roth IRA can grow at a 6% rate of return, it will take you a minimum of 10 years to break even. In 2011, the top tax rate will be 45%, and at a 6% rate of return, the breakeven point is would take more than 11 years.
Assuming you have the liquidity to pay the taxes due, should you convert? For anyone under the age of 50 who has the time for the investment to grow, yes. However, you are also betting that the government won’t change the tax rules on distributions by the time you are ready to withdraw. Between the ages of 50 to 60, those investors need to look very, very closely at the numbers. For investors older than 60, converting generally does not make sense unless you are viewing it from an estate tax point of view. Additionally, at 60, investors are not converting $100,000. They are likely converting traditional IRAs worth $1,000,000 to $2,000,000. They would be paying $400,000 or more in taxes.
To us, it is no surprise that Uncle Sam lifted the $100,000 AIG limit on ROTH conversions—the government needs the tax money. The ability to split the tax liability over two years is no gift either, as income tax rates are going up in 2011.
One unique way to work the system is a process of recharacterization and reconverting. For example, you have 10 different $10,000 IRA portfolios, all with different investment strategies. You convert each to a Roth IRA, and at the end of the year, which ever portfolios lost value, you recharacterize and convert back to a Traditional IRA so you do not have to pay the taxes due. It is certainly an interesting strategy, but it requires an investor to stay on top of it. There are some additional rules in the recharacterization process, so it would be best to work with a financial adviser with experience in this strategy.
If converting your Traditional IRA to a Roth IRA is part of your estate plan to minimize estate taxes, it is probably better to convert it now and pay the taxes due. If your children or grandchildren are beneficiaries of your IRA, they would be well-advised to take advantage of the ability to take withdrawals from the inherited Roth IRA over their life expectancy. The funds in the Roth IRA will continue to grow and compound tax-free while still part of the Roth IRA and the distributions from the Roth IRA will be tax-free as well.
