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Is a Roth IRA conversion on your year-end checklist?

December 02, 2013

If you own a traditional IRA, you can convert all or part of it to a Roth IRA and pay income taxes on the pre-tax balance of the traditional IRA.

Why would you want to pay taxes sooner rather than later? In the case of a Roth conversion, doing so would give your account the opportunity to grow tax-free in the future. Plus, there are benefits that a Roth IRA has over a traditional IRA.

Roth or traditional … or both?

With a traditional IRA, you make contributions with pre-tax dollars and defer paying taxes until you make withdrawals. But with a Roth, you contribute after-tax dollars and you're able to withdraw earnings from the account without paying taxes or penalties once you've reached age 59½ and have held the account for at least five years.

Both types are tax-efficient tools to help you save for retirement. The best match for you depends on your specific financial situation and retirement goals.

Learn more »

Why convert?

For many investors, holding both Roth and traditional IRAs provides the most long-term tax planning flexibility.

"Putting at least part of your retirement assets in a Roth gives you tax diversification, which can help insulate you from uncertainty with future tax policies," said Maria Bruno, a senior investment analyst with Vanguard.

Maria BrunoSpreading your retirement savings across Roth, tax-deferred, and taxable assets can provide flexibility in managing tax-efficient withdrawals during retirement and can also help maximize wealth transfer to future generations, she said.

"If tax rates go up in the future, or if you eventually move into a higher marginal tax bracket, you will have essentially paid the conversion income taxes at today's lower rate," Ms. Bruno added. "And you'll start the clock on the tax-free growth that a Roth offers."

If you convert to a Roth IRA in 2013 and subsequently change your mind, you have the option to "recharacterize" all or part of the converted Roth IRA back to a traditional IRA next year. There's a deadline, though: for a 2013 conversion, the recharacterization window will be open until October 15, 2014.

"The ability to recharacterize definitely offers tax planning flexibility in the near term," said Ms. Bruno.

Some points to ponder

  • No lifetime RMDs. While you can make withdrawals from your Roth account at any time (although you could incur penalties if you withdraw earnings before age 59½ or before the required five-year holding period has passed), there are no required minimum distributions (RMDs) during your lifetime. That means the money you invest can stay invested and continue to grow tax-free.

    "If you don't anticipate tapping your Roth IRA during your lifetime, it can be an attractive asset to pass along to future generations," Ms. Bruno said.
  • Roth IRA withdrawal tax perks. Distributions from Roth IRAs don't count toward modified adjusted growth income threshold that determines whether you're subject to the new 3.8% Medicare investment surtax. Traditional IRA withdrawals, on the other hand, do count, and could potentially trigger this tax. Also, Roth withdrawals aren't included as income for the purposes of calculating whether your Social Security benefits are taxable. (However, the income is included in the calculation the year you do the conversion, which is likely to affect your benefit for that year only.)
  • Lower estate taxes? A Roth IRA can help reduce the taxes your heirs will owe on your estate. While both traditional and Roth IRA assets are included in an estate's value, the income taxes you've already paid when you converted to a Roth, as well as the potential appreciation those tax dollars would have earned, are removed from the estate's value.

    "There's an interplay between income taxes and estate taxes, depending how large your estate is," Ms. Bruno said. "And with a Roth your beneficiaries won't have to pay income taxes on any withdrawals they make."
  • Basis matters with a Roth IRA. If you need to tap the account, a Roth IRA offers flexibility because there are unique withdrawal ordering rules from a tax-reporting standpoint. For example, when taking a distribution it's assumed that you take first take your "basis"—the money you originally invested, which had already been taxed at the time of the contribution—followed by rollovers and conversions (withdrawals from the original conversion amount are penalty-free beginning five years from the conversion year), and finally investment earnings. The tax efficiency and flexibility this provides is another advantage of investing in a Roth IRA. With a traditional IRA, on the other hand, withdrawals are subject to taxes "pro rata" across basis and earnings.

What to consider if you're converting this year

The pre-tax balance of the traditional IRA you're converting will be considered taxable income. That means you'll want to consider what this does to your overall 2013 tax picture.

Depending on the amount you convert and your tax situation, you'll want to consider whether the additional income might bump you into a higher tax bracket. It may also raise your income level to a point where you'd be subject to the new 3.8% Medicare investment surtax. If this is the case, don't quite shut the door on the conversion quite yet, as are other tax considerations.

For example, you could consider offsetting some of the conversion income with a charitable contribution. While the Roth conversion would increase your income, charitable contributions would have the opposite effect. You could give more to causes you care about and, perhaps, the higher adjusted income could even raise your charitable deduction cap.

The alternative minimum tax (AMT) may be another consideration. If you're subject to the AMT, the higher income might result in a smaller AMT obligation.

The point here is that while you're increasing your taxable income with the conversion, there are some strategies you can employ in the year you perform the conversion to help offset the brunt of the conversion tax. Consulting a qualified tax-planning professional to discuss these strategies may be wise.

Lastly, Ms. Bruno said, you should aim to pay taxes on your Roth conversion with money that's separate from your retirement savings. That way, your entire traditional IRA moves to the Roth account, maximizing the tax-free growth potential.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Diversification does not ensure a profit or protect against a loss.
  • When taking withdrawals from a traditional IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
  • Withdrawals from a Roth IRA are tax-free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both.
  • We recommend you consult a professional tax or financial advisor for specific guidance on your individual situation.
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