Traditional IRA. Roth IRA. What’s the difference? And should you, as many headlines have recently suggested, swap one for the other?
Only the first question is easy. The traditional IRA allows you to sock money away and get an immediate tax deduction. But when you eventually withdraw the funds, you pay tax.
The Roth, in contrast, gives you no deduction stepping in, but you pay zero tax when taking the money out. In other words, the traditional IRA offers tax-deferred growth; the Roth offers tax-free growth.
The ability to convert from the traditional to the Roth is nothing new. That’s been allowed since 1998. As of January 1, 2010, however, there is no longer a $100,000 income cap on who can convert to a Roth. Now anyone can. All you have to do is pony up the taxes due. But just because you can convert does not mean that you should.
“For many people the conversion can make enormous sense. For others it can be a disaster,” says Robert Keebler, CPA, MST, a partner in the accounting firm of Baker Tilly Virchow Krause, LLP, in Appleton, Wisconsin.
Which group are you in? Here’s how to tell:
Will your future tax rate go up?
With the federal debt mounting and personal income tax rates lower than they’ve been in decades, taxes overall are likely to rise. But what about your personal tax bracket? That is perhaps the single biggest consideration in deciding whether to convert.
“If you are paying 30 percent in taxes today, or 30 percent tomorrow, you are, in a strict mathematical sense, going to be no better or worse off by converting,” says Keebler. If you expect your taxes to rise in future years, however, you are a good candidate for conversion. If you expect your taxes to fall, which might be the case for a highly paid professional looking to retire soon, the conversion will probably not make sense.
When will you need the IRA funds?
The longer you have before tapping the funds, the more the Roth can grow tax-free and the more the conversion will help secure your nest egg. If you plan to use the funds within the next three to seven years, converting to a Roth probably won’t work to your advantage, says Keebler. If, on the other hand, you plan to not touch the money for decades, or perhaps never touch the money—leaving it to your kids, for example—the Roth conversion may add substantially to family wealth, he says.
Do you have the cash to pay the taxes now?
If you convert, say, $20,000 of your traditional IRA to a Roth this year (you can choose to convert all or part of your traditional IRA), you will likely owe income taxes (both federal and state) on the $20,000. If you are in the 30 percent total tax bracket—assuming the $20,000 doesn’t push you up into a higher tax bracket—you’ll have to cough up an extra $6,000 ($20,000 x 30 percent) by tax time. Or, you can take advantage of a special law currently in effect that allows you to defer recognizing the conversion income until you file your 2011 and 2012 tax forms. “Either way, the conversion will be more advantageous if you have the cash outside of your IRA to pay the tax,” says Scott Jacobsmeyer, CFP, president of Argent Wealth Management in Round Rock, Texas. In addition, he warns, if you pay the tax due out of the IRA and you are not yet 59 1/2, you may be subject to a 10 percent penalty.
Fortunately, you don’t need to figure this all out today. To convert for tax year 2010, you need to make your move by the end of December. And there’s always next year … and the year after that. “In fact,” says Jacobsmeyer, “for many people, partial conversions over a number of years (so you’re not taking too big a tax hit in any one year) might be the best strategy of all.”
Just about every brokerage house now offers Roth-conversion calculators online (check the sites below). “The calculators can be useful tools and a good place to start,” says certified financial planner Scott Jacobsmeyer. But he warns that they all use assumptions that may be true for the masses, but not necessarily for you. “To get the clearest picture possible, you should consult a financial professional. The question as to whether to convert is, unfortunately, rather complex.”
Russel Wild, MBA, is a NAPFA-registered financial adviser who has written nearly two dozen books, including Index Investing for Dummies and Bond Investing for Dummies