The Roth Conversion Essentials


With the tax season in full swing and new rules in effect, brokerage and mutual fund companies report a flood of inquiries from investors wondering whether to convert traditional IRAs into tax-free Roths.

The new rules are simple, but the conversion decision is not. So here is the first of five columns that will examine the question over the next two weeks by looking at tax implications, benefits for heirs and how to undo a conversion if you change your mind, among other topics.

Though the tax season has helped fuel investors’ interest, a conversion done now, or anytime in 2010, will not affect the 2009 return due April 15. It could increase your tax bill for 2010. Or you would have the option of dividing the tax bill between 2011 and 2012, a deal only available for conversions done this year.

The other factor in investors’ new-found interest is a rule that took effect Jan. 1 allowing anyone with a traditional IRA, or TIRA, to convert it into a Roth. Previously, investors with modified adjusted gross incomes of more than $100,000 were not allowed to convert.

The first step is to understand the differences between the TIRA and Roth. With the TIRA, investors contribute pre- or after-tax dollars and avoid all annual income and capital gains taxes as the account grows. Upon withdrawal, all previously untaxed money such as investment gains and tax-deductible contributions are taxed at income-tax rates, ranging from 15% to 35% for most investors. Most investors also face a 10% penalty on withdrawals before age 59 ½, and withdrawals must begin after 70 ½.

Roths offer no upfront deduction on contributions but all contributions and investment gains can be withdrawn tax-free, generally after the account holder turns 59 ½. Investors are not required to begin withdrawals after 70 ½, allowing the accounts to grow longer and making Roths kinder to heirs.

In a conversion, the investor turns a TIRA into a Roth, getting all the Roth benefits such as tax-free treatment of withdrawals. But there’s a catch: income tax must be paid on any sums that had not been taxed before — investment gains and TIRA contributions on which tax deductions had been taken.

The tax bill must be paid the year the conversion is done, though the one-time exception for 2010 allows the bill to be spread over 2011 and 2012 if the investor prefers not to pay it all this year. This can be an important consideration, as converted sums subject to tax are added to the investor’s income. Dividing the conversion over two years makes it less likely these sums will raise the investor into a higher tax bracket.

Of course, the investor can also avoid this problem by spreading the conversion over two or more years. There’s no requirement that all the investor’s TIRAs, or even the entire sum in a single TIRA, be converted. You can convert as much or as little as you like.

The conversion decision boils down to this: by converting, you pay tax today to avoid tax in the future — the one you’d pay if you kept the TIRA.

Two factors dominate the calculation: Will your tax bracket be higher in the future than it is now, making the conversion more beneficial? Do you have funds outside of the TIRA to pay the conversion tax? Those subjects will be covered over the next few days. In the meantime, the Roth IRA Conversion Calculator can help determine whether a conversion would pay for you.

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