Convertin Your IRA to a Roth

A lot of clients have asked about converting regular IRAs to Roth IRAs. This is a complicated question.

Let’s start with the basics. You usually get to deduct the money you contribute to your regular IRA while there is no deduction for contributions to a Roth IRA. You pay taxes on the money you take out of your regular IRA. There may be some adjustments but the distributions are a taxable event. If you meet the requirements for a Roth IRA you do not pay tax on money you take out of it. So Roth distributions generally are tax-free.

You are allowed to convert a regular IRA to a Roth IRA. Here is the problem: you pay taxes on the amount you move from your regular IRA to a Roth IRA. You need to pay these taxes out of money that is not in the IRA. So if you have a $10,000 tax liability for making one of these conversions, it must come out of other investments or savings account. If you use the IRA money to pay the taxes you might end up paying some penalties and taxes.

Why do a conversion? You do not have to pay taxes on future earnings in the Roth IRA assuming you meet the requirements of having it in the account for five years and being over 59-1/2. There are some exceptions to these rules.

You are paying current taxes to save future taxes. If you left the money in the regular IRA you would eventually pay taxes on all the earnings when you withdrew it from the account. You do not pay these taxes on the Roth.

Here is the big problem. You can pay as much as 40% in taxes on the value of the IRA that you convert to a Roth. This happens if you are in a high tax bracket. Even if your income were about $100,000 you would pay about 33% in taxes on the conversion. That’s a lot of money.

I have analyzed this conversion for several clients. The results have consistently come in that doing the conversion does not result in significant savings for the client. After taxes were considered the clients would end up with the same amount of money whether or not they did the conversion.

The one kicker that investment advisors keep throwing on the table is that tax rates are probably going up so pay the taxes now. I have a problem with paying a lot of taxes now based on what Congress might do in the future.

A conversion like this could benefit a low-income taxpayer, perhaps someone who lost a job and had very low income this year but expects to re-enter the workforce soon. This could result in some future benefit. Analyze your situation carefully if you are thinking about doing this type of transaction.