Should I convert my traditional IRA to a Roth?July 5, 2011: 5:05 AM ET
Everyone says that federal income tax rates will rise, but how far? I'm trying to decide whether to convert my traditional IRAs to Roths. —Michael Beach, 41, Sterling, Va.
Finding a sage who can forecast what our notoriously fickle legislators will do on the tax front in your lifetime is about as easy as finding someone who can predict the winners of the World Series each year. So while it's true that most experts do expect tax rates to rise, you'll have to make your conversion decision in the face of uncertainty.
The major advantage of a Roth IRA is that you can withdraw funds tax-free in retirement and possibly even sooner. So in general it makes sense to convert from a traditional IRA and pay the tax bill now if you think you'll be in the same or a higher bracket after retirement (there are even times that you'll come out ahead if you drop into a lower tax bracket).
Keep in mind, though, that should tax rates go up, it's not a given that those higher rates would apply to you. Much of the talk about tax hikes so far has centered on boosting rates for singles with income above $200,000 and couples over $250,000; if your income falls below that lofty level, higher rates could be a nonevent as far as your conversion decision is concerned. "It's your personal tax rate that matters," says Maria Bruno, an investment analyst at Vanguard.
Plus, under our system of graduated tax rates, not all your income is taxed at the highest marginal rate. This means it would still make sense to have money in traditional 401(k)s and IRAs that would be subject to the lowest-rate tiers (now 10% and 15%).
Given all this, your best course is to hedge your bets by having some money in tax-free Roth accounts and some in tax-deferred 401(k)s and IRAs. The greater you think the chances are that your tax rate will rise, the more you'll want to devote to a Roth. You may also want to use a Roth to pass money on to your heirs tax-free.
Remember, however, that converting creates taxable income in and of itself. So to prevent the conversion income from pushing you into a higher tax bracket, you may want to convert small amounts over time. Similarly, the extra conversion income could also boost your adjusted gross income, which could reduce your ability to take some itemized deductions.
Finally, the chances of a Roth conversion paying off are higher if you pay the conversion tax with funds from outside the IRA that you're converting, since that leaves more money to grow tax-free within the Roth.
-- Walter Updegrave
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