If you didn’t have to pay taxes, what would you do with the money?
The issue isn’t as simple as it sounds if you’re among the many investors thinking about converting a traditional IRA into a Roth IRA come 2010, when people with incomes more than $100,000 will no longer be barred from this move. (For a rundown on Roths, look at this T. Rowe Price (Stock Quote: TROW) explanation.
The conversion involves paying tax on investment gains and tax-deductible contributions contained in the traditional IRA, just as you would if you made withdrawals in retirement. But once the tax is paid, all contributions and investment gains in the Roth IRA will be tax-free.
The issue that draws the most attention is whether it’s best to convert and pay tax today, or to keep your traditional IRA and pay tax on withdrawals years in the future. Generally, it’s best to pay tax whenever you are in the lowest tax bracket, making a conversion a better bet if you think your tax rate is lower now than it will be when you withdraw money later.
But there’s a second issue that can easily tip the balance in the conversion decision: If you do not convert, how much could you earn by investing the money you’d save by avoiding the tax you would have paid?
If you were to invest that money, it might well make sense to forgo the conversion and keep your traditional IRA.
Take a look at the Roth IRA Conversion Calculator. The blue, purple and yellow bar graph compares three options. With the default figures, a conversion to a Roth produces a bigger gain than sticking with the traditional IRA.