Apr 10

Is it Time to Convert Your Traditional IRA?

by Anthony Farella

Individuals are permitted to convert their Traditional IRAs (“TIRA”) to Roth IRAs if they meet current income limitations set by the IRS.  In 2010 the income limits are removed allowing anyone to convert.  I set out to examine when OR if a client should convert their traditional IRA to a Roth IRA.

Facts:

1) Individuals converting to Roth IRAs must add the amount of conversion to their income and pay federal and state taxes on the converted amount at their highest marginal tax rates.

2) For any conversions in 2010, tax liability can be spread equally over the 2011 and 2012 tax year.

3) Conversions are designed to be tax neutral.  If client IRA assets are invested the same way in either a Traditional or Roth IRA, and marginal tax rates are the same, then after-tax income is the same for either IRA account.  See example:

TIRA v. Roth IRA Tax Rate Deposit Avg Growth Rate Balance in 20 Yrs After-tax Balance
Roth IRA 32% $6,800 8% $31,695 $31,695
Deductible TIRA 32% $10,000 8% $46,610 $31,695

4) Higher or lower after-tax spendable income only occurs if future tax rates are different from current tax rates.  For example, if future marginal tax rates are higher, then a Roth IRA would produce more after-tax income.

5) Roth IRA’s are NOT subject to required minimum distributions.

 

Analysis:

•  Client who has 2 assets – TIRA and Brokerage account (assumes 1.3% return loss to income taxes on the brokerage account – 70/30 portfolio):

TIRA v. Roth IRA Tax Rate Deposit After-tax Growth Rate Balance in 20 Yrs After-tax Balance
TIRA 50% $100,000 8.0% $466,096 $233,048
Brokerage 50% $50,000 6.7% $182,919 $155,481
Total TIRA/Brokerage $150,000 $649,015 $388,529
Roth IRA 50% $100,000 8.0% $466,096 $466,096

While I cannot say there are hard or fast rules on when or if to convert an existing traditional IRA, below are some situations where the decision becomes easier to make:

YES – Convert

•  For clients with after-tax investments, who are in a high marginal tax bracket and will be in a high marginal tax bracket during retirement;

•  Clients who are subject to estate taxes;

•  Clients who wish to pass their Roth IRA accounts tax free to their beneficiaries and future generations.

NO – Don’t Convert:

•  Anyone who has to pay the tax with existing IRA assets (no brokerage or savings);

•  Clients in retirement living off their IRA money;

•  Clients who are sure to be in a lower tax bracket at retirement.

Please contact me for a more detailed analysis if you are considering a Roth conversion

About the Author

Tony Farella, is a Certified Financial Planner® and a Principal Founder of Rockbridge Investment Management.  Tony is a contributor to Forbes, CNN Money, NAPFA’s FI Guide, Advisor Perspectives and local tv, radio and print publications.  Tony is the board director for NAPFA New England-Mid Atlantic Region), previous board member of the Financial Planning Association of CNY, acting Board Member of the Downtown Syracuse YMCA, as well as the Board of Directors for Countryside Credit Union.
Learn more and/or Contact Tony »


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