Traditional IRA to Roth IRA Conversion Options A
How to Minimise Taxes on Conversion From Traditional to Roth IRAs
Apr 13, 2009
Many people who owns traditional IRA accounts are now faced with a dilemma. Should they convert their Traditional IRA accounts to Roth Accounts and if yes, what are all the factors to consider before they take that important decision?
The decision to convert or not must be taken after carefully considering many factors, including the current tax rates compared to those at the time of retirement, how the taxes due on conversion will be paid, how much time is left for retirement, whether the contributions are mostly deductible or non-deductible, etc.
Difference between Traditional and Roth Accounts
There are many differences between a Roth account and a Traditional IRA account, but the most important difference is that unlike the traditional IRA account, there is no tax-deduction for contribution to a Roth IRA account. The advantage of Roth over Traditional is that there is no tax on the earnings (as well as the contributions) when the amount is withdrawn.
In a Traditional IRA there is a tax deduction for contribution (for those who are eligible) but the account holder pay taxes on earnings and contributions at the time of withdrawal. In other words, if a person contributed a total of $50,000 to a traditional account and the account grew to $300,000, he will have to pay tax for the whole $300,000 at the time of retirement, when he starts withdrawing it.
In a Roth Account the account holder gets no tax deduction at the time of contribution, but he gets the whole $300,000 when he retires, with Uncle Sam claiming not a single penny of it! Sounds tempting, doesn't it?
It is indeed tempting not having to pay taxes on the earnings but there is one important aspect to consider while planning a conversion. When a traditional account is converted to a Roth account, the account holder owes taxes on earnings and pretax contributions to the account. Basically, it is the total amount in the account minus the total of non-deductible contributions made to the account. This amount is taxed as ordinary income.
Consider converting to a Roth account after reading the following:
Who Will Pay for Conversion?
It is never a good idea to use the IRA money to pay the conversion tax. If the account holder is younger than 59 1/2, she will have to pay a 10% penalty on that amount. Plus she will also give up the opportunity for tax-free Roth IRA compounding of that amount.
How Much Time Until Retirement?
In general, the younger a person is, the more beneficial a conversion will be. That's because there will be more years to make up for the taxes that you pay for conversion. Further, there will be more time for the money inside the Roth IRA to grow significantly.
Will the Income Tax Bracket Drop After Retirement?
If there will be a significant difference between the tax rates before and after retirement, it is probably not a good thing to convert at the current higher tax rates. However if there is only a slight difference, conversion still might be advantageous. Some people think that we are currently enjoying the lowest tax rates and that tax rates are likely to go up in the future. If they are right, this may be the ideal time to convert, but then again, they may be wrong.
Are the Contributions Mostly Non-Deductible?
If the contributions are mostly non-deductible, it makes sense to convert the account to a Roth Account. The account holder cannot enjoy the basic advantage of a Traditional IRA account (no tax deduction) and he also has to pay taxes on the earnings. Further there is no tax for non-deductible contributions at the time of conversion.
Will the Conversion Push the Account Holder into a Higher Tax Bracket for the Conversion Year?
Since the amount taken for conversion is considered as ordinary income, there is a risk that a person in the lower tax bracket may be pushed up to a higher tax bracket disqualifying him for tax benefits, such as credits and deductions.
Another major factor to consider is that the tax burden may be much more bearable if the conversion is made in the current year, since the account holder owes taxes on the investment earnings as well as the contributions. With markets hitting an all-time low, the investment earnings portion is likely to be much lesser than it was before an year or two.
 |
