Should You Consider a Roth IRA Conversion in 2010?

    by Christine Fahlund

    Should You Consider A Roth IRA Conversion In 2010? Splash image

    Since Roth IRAs became effective in 1998, they have offered a compelling option for eligible retirement investors.

    But many remain uncertain whether it pays to convert assets already invested in a traditional IRA into a Roth IRA.

    As a result of the new tax act passed earlier this year [the Tax Increase Prevention and Reconciliation Act], more investors will have the option of doing a Roth IRA conversion. Prior to the act, only IRA investors with modified adjusted gross incomes of $100,000 or less for a tax year could convert all or part of the money in their traditional IRA into a Roth IRA in that year.

    Starting in 2010, the $100,000 adjusted gross income limit will be removed so anyone will be able to do such a conversion.

    Even investors with relatively high annual incomes who are approaching retirement or recently retired, as well as those still years from retirement, may find it worthwhile to consider a Roth IRA conversion.

    Those in or nearing retirement might even roll over some of the assets in an employer-sponsored retirement plan into a traditional IRA with the intent of then converting the money into a Roth IRA.

    The advantage is that future earnings in the Roth IRA can be withdrawn tax-free in retirement (after age 59½) if the account has been established for at least five years. However, at the time of conversion the investor has to pay income taxes on the taxable amount of the traditional IRA (earnings plus deductible contributions) converted to a Roth IRA. (The 10% premature withdrawal penalty does not apply to conversions regardless of age.)

    Therefore, investors must examine whether it is better to pay taxes now in order to be able to withdraw earnings from a Roth IRA income-tax-free later during retirement, or leave the money in the current traditional IRA, where it will continue to grow tax-deferred but all earnings and deductible contributions will be taxed upon withdrawal. (Note: In 2010 only, investors who do Roth conversions will have the option of paying the taxes due on the conversion ratably over a two-year period.) Generally speaking, investors should plan to pay any taxes due using assets held outside of their IRA so that the full IRA amount can grow tax-free in the Roth IRA.

    Key Considerations

    Some of the factors to consider in making this decision include:

    • How much time you have until you begin taking the money out of your IRA and how long you expect to make withdrawals from your IRA after you retire.

    • Your current tax bracket and projected tax bracket in retirement.

    • Whether or not you will want to avoid taking required minimum distributions from your IRA after reaching age 70½, since minimum distributions are not required for Roth IRA accounts by account owners, although they are by their beneficiaries after the owner’s death (assuming the surviving spouse does not roll the money over to his or her own Roth IRA).

    • Whether or not you would like to leave assets in a Roth IRA as an income-tax-free legacy to your heirs, if possible.

    • The rate of return you expect to earn on your savings before and during retirement.

    • How you pay the taxes due on the conversion—either by taking the money from your existing IRA (thus reducing the amount you can convert) or taking it from other assets.

    Generally, the longer the period until you start taking the money out of the account and the higher the expected rate of return, the more advantageous it may be to convert at least some of the traditional IRA money into a Roth IRA. That’s because the more you can accumulate in the Roth IRA by retirement, the greater the benefit of its tax-free withdrawals.

    Although it may be impossible to project, your potential tax bracket in retirement is also important. If your tax rate drops significantly after retirement, it may not be beneficial to do the conversion since you would be paying tax on the current earnings (and deductible contributions) at a higher rate now rather than at a lower rate in retirement.

    On the other hand, if your tax rate rises between now and your retirement, the conversion could be more attractive since taxes due as a result of the conversion would be paid at the lower rate now, while future earnings would presumably be withdrawn tax free—at a time when your tax rate is higher.

    To get an idea of how these factors may come into play, let’s look at some hypothetical cases.

    To Convert or Not to Convert

    Table 1 summarizes the results for two investors, both with modified adjusted gross incomes under $100,000:

    • One is 45 years old (20 years from retirement at age 65) with a $25,000 deductible IRA; and

    • The other is 55 years old (10 years from retirement at age 65) with a $50,000 deductible IRA.

    In both cases, all IRA assets are subject to taxation since they consist of deductible contributions, earnings, and other pretax contributions that were transferred into the IRA from other qualified retirement plans, such as a 401(k) plan.

    The analysis reflected in Table 1 shows:

    • How much each would have to pay in current taxes if the assets were converted into the new Roth IRA;

    • The pretax value of the accounts at retirement; and

    • How much these investors might receive in total aftertax withdrawals over a 30-year retirement period if they convert to a Roth IRA or retain their current IRA.

    In this example, in the long run, both investors would receive more spendable retirement income by making the conversion, but they have to go through the tax toll booth to do so.

    Note that for each investor the amount due in taxes as a result of the conversion is not deducted from the amount converted into the Roth IRA, but rather the full amount from the traditional IRA is invested in the new account. That means if they convert they must come up with the taxes due from other savings. Therefore, to make a valid comparison with the case where the individual does not convert, we assume that the “tax savings” (the amount that would have been paid in taxes if the conversion were made) is invested in a separate taxable account. This is reflected in the table. These earnings are added to the deductible IRA when comparing it with the Roth IRA results.

    In the case of the 45-year-old investor with a $25,000 conversion, the Roth IRA would have provided $20,237 more in aftertax income over the retirement period than if the conversion was not made. (This takes into account the $7,188 in taxes that had to be paid the year the conversion was done.)

    The 55-year-old investor would have gained $13,533 in additional retirement income (taking into account the $14,375 tax bill to make the switch).

    Keep in mind that these comparisons include the value of investing the imputed tax savings that would be available if the conversion were not made. As can be seen in the table, the Roth IRA’s advantage is considerably greater in a head-to-head comparison if the side account representing the tax savings is not included. This might occur if the money which would have been used to pay taxes on a conversion were not invested.


    Different Tax Rates in Retirement
    In this analysis we assumed that the investor’s 25% federal tax rate (and 5% state tax rate) did not change after retirement.

    But what if the tax rate were higher or lower in retirement?

    A higher tax rate in retirement would make the Roth conversion even more attractive. However, if the federal tax rate dropped from 25% to 15% after retirement, maintaining the existing IRA would provide a modest advantage in total aftertax withdrawals. This is reflected in Table 2.

    As noted, for purposes of comparison, our analysis also assumes the “tax savings” from not doing the conversion—the amount that would have been paid in taxes—remains invested in a separate taxable account. If that money were instead used to invest in another tax-deferred retirement account on a pretax basis—such as a 401(k) plan—the total aftertax withdrawals in retirement would be the same as provided by the Roth IRA—and even greater if the investor’s tax rate dropped in retirement.

    Table 2. The Impact of Tax Rates on the Conversion Decision(25% Tax Rate Prior to Retirement)
      Total After-tax Distributions in Retirement With Tax Rate of:
    15% 25% 35%
    45-year old
    Trad'l Deductible IRA $242,416 $219,348 $196,282
    Roth IRA 239,585 239,585 239,585
    55-year old
    Trad'l Deductible IRA $229,814 $208,415 $187,017
    Roth IRA 221,948 221,948 221,948

    Conversions From Non-Deductible IRAs
    What if the investor is considering converting assets from a non-deductible IRA instead of a deductible one?

    In this case, only the earnings in the account would be subject to taxation since the original contributions have already been taxed.

    Our analysis showed that in most cases, converting a non-deductible IRA to a Roth is also attractive when the taxes are paid from a separate account rather than from the IRA. This can be seen in Table 3. (Note: If an investor has one or more IRAs consisting of deductible and non-deductible contributions, all of these assets must be considered in determining how much of the converted amount is subject to taxation.)

    Keep in mind that the taxable amount converted into the Roth is considered taxable income in the year the conversion is made, whether the conversion is from a deductible or non-deductible IRA. Therefore, it is possible that a large conversion could push you into a higher tax bracket in the year the conversion is made, increasing the tax due on the converted amount. For that reason, you might prefer to convert portions of your traditional IRA over several years, rather than doing it all at once.

    Your tax rate in retirement can also influence the appeal of a Roth IRA conversion from a non-deductible IRA. The effect of different tax rates in retirement is reflected in Table 4.


    Retirees and Roth Conversions

    In the above examples, we focused on those within 10 to 20 years from retirement. But what about current retirees—should those who have recently retired or are about to retire also consider a Roth IRA conversion?

    Let’s look at a similar analysis for a hypothetical 65-year-old investor with a modified adjusted gross income under $100,000 who has accumulated assets in a traditional deductible IRA account, or a 401(k) account that could be rolled over to a traditional IRA and then converted to a Roth IRA.

    Table 4. The Impact of Tax Rates on Roth IRA Conversion Decisions From a Non-Deductible IRA (25% Tax Rate Prior to Retirement)
      Total After-tax Distributions in Retirement With Tax Rate of:
    15% 25% 35%
    45-year old
    Non-Deductible IRA $224,440 $202,287 $180,134
    Roth IRA 239,585 239,585 239,585
    55-year old
    Non-Deductible IRA $212,598 $212,786 $173,406
    Roth IRA 221,948 221,948 221,948

    $100,000 Conversion
    If the investor converted $100,000 of these assets, his marginal federal/state tax rate in the year the conversion is done would jump from the bottom of the 25% federal income tax bracket to 31.6%, since the amount converted is considered taxable income for that year (except for conversions in 2010, as noted earlier). Assuming his tax bracket in retirement reverts to 28.75% after the year of the conversion, the conversion would provide a modest advantage. This is illustrated in Table 5.

    In other words, this investor would receive more in total aftertax withdrawals from the Roth IRA over 30 years in retirement than from the deductible IRA (plus the taxable side account), based on the same assumptions used in the prior examples.

    If this investor’s marginal federal/state tax rate in retirement was 31.6% or higher, the advantage from doing the conversion is even greater.

    In this analysis, the taxes due on the Roth conversion are assumed to be paid from another source than the IRA account itself. If the taxes were taken out of the IRA to pay the tax due, the conversion would not be worthwhile unless the investor’s effective tax rate in retirement was at least 28.75%. (At that tax rate, it would make sense to convert a maximum of $59,571.)

    If the investor’s effective tax rate in retirement were 31.6% or higher, it would be worthwhile to convert the full $100,000 even if the taxes due on the conversion were taken out of the IRA account.


    $500,000 Conversion
    Table 6 reflects the results of the same analysis for a $500,000 conversion from a traditional deductible IRA account into a Roth IRA.

    In this case, the $500,000 conversion pushes the marginal federal/state tax rate in the year of conversion to 38.25%. For this investor, if his marginal federal/state tax rate in retirement reverts to 31.6% after the year of conversion, the conversion would provide an advantage. If his marginal tax rate reverts to 28.75%, smaller conversion sizes yield modest advantages.

    Non-Deductible IRA Conversion
    What if this investor were considering a $100,000 Roth conversion from a non-deductible IRA account?

    In that case, we generally found that the conversion would be worthwhile assuming the taxes due on the conversion were paid from another account and the investor’s effective marginal tax rate in retirement was at least 28.75%.

    This conversion could still be worthwhile even if the tax amount due were taken out of the IRA, assuming the investor’s cost basis in the IRA account is $25,000 and his effective tax rate in retirement is at least 28.75%.


    Other Roth Benefits

    In addition to any future earnings growing tax-free, another benefit of a conversion is that the investor (and surviving spouse if he or she rolls over the assets) does not have to start making minimum withdrawals from the Roth IRA at age 70½, increasing the time the assets can continue to grow free of taxes.

    Also, if you take distributions before age 59½, it may be possible to avoid taxation or penalties with the Roth, since any distributions from a Roth IRA are considered to be a return of your contributions first and then earnings.

    For those who plan to leave part or all of their Roth or traditional IRA assets to a beneficiary, the beneficiary may be able to continue to defer taxes on the assets and simply take required minimum withdrawals from the account over the beneficiary’s remaining actuarial life expectancy. Beneficiaries can take more than the minimum amount at any time. Most beneficiaries who are spouses roll over the assets they inherit into an IRA of their own instead. However, the Roth IRA provides a potentially significant benefit for beneficiaries, since all the distributions over this extended period can be income-tax-free, whereas all earnings and deductible contributions withdrawn from an inherited traditional IRA will be taxable to the beneficiary.

    A Roth IRA is one of the most valuable assets a couple can leave their children and/or grandchildren. The investments are tax-sheltered, the income can be tax-free, and, after the death of the Roth IRA account owner, those who inherit the assets can make withdrawals based on their own life expectancies.

    Nevertheless, investors must weigh the upfront tax costs against the long-term tax advantages of an IRA conversion.

    The IRA analyzer tool on the T. Rowe Price Web site ( can help you gain perspective as to whether a conversion may be worthwhile, given your personal circumstances and assumptions regarding future investment returns and marginal tax rates.

→ Christine Fahlund