How to Pace Out Roth Conversions

Feeling patriotic? Show it, then – with a Roth conversion. This year!

On the other hand, relax. You probably won’t hurt yourself too much by waiting another year or two – or even longer. Either way, Uncle Sam will get his money.

An opinion piece in The Wall Street Journal argues that taxes on Roth conversions could reduce next year’s federal budget deficit by anywhere from 15% to 50%. That could really help the country out of a jam.

Two factors could cause a flood of conversions this year. First, wealthier investors with enormous sums in traditional IRAs, 401(k)s and similar plans eligible for conversion will jump at the chance to do it now that they can. Before Jan. 1, conversions were limited to households earning less than $100,000 a year.

Second, anyone who converts in 2010 has the option of dividing the tax bill between 2011 and 2012. In addition to making it easier to come up with the tax money, this could reduce chances the converted sum would kick you into a higher tax bracket when added to your income.

So, the article says, many people will rush to convert this year. Because tax must be paid on most converted sums – everything but nondeductible IRA contributions – that could produce a flood of revenue for the federal government. Hooray!

OK, but what if you just don’t want to do it this year? Conversions may well make sense, as Roth withdrawals are tax-free while money taken from traditional IRAs is taxed. But to make a conversion worthwhile, you must have money lying around to pay the conversion tax. If you pay tax out of sums in the IRA, your new Roth will start out so far behind it may never catch up.