The Benefits of Converting Your IRA to a Roth


	Kelly White

November 2009

The Benefits of Converting Your IRA to a Roth

Converting a traditional IRA to a Roth is a taxable event, but it may be the most welcome tax hit you will ever take

If your traditional IRA has dropped in value and you expect to pay higher federal income tax rates in future years, now might be a very good time to consider converting all or part of your traditional IRA balance into a Roth IRA.

Here’s why. If you convert, it will trigger a current tax hit on the amount you convert. But with your traditional IRA balance at a depressed level (and possibly your overall income, too), the tax hit will be less. After the conversion, your new Roth IRA balance can grow without being taxed by Uncle Sam. Eventually you can take tax-free withdrawals after age 59½, when your marginal tax rate may be higher (perhaps much higher) than it is right now.

Roth Conversion Basics. A Roth conversion is treated as a taxable distribution from your traditional IRA because you are deemed to receive a taxable payout from your traditional IRA, with the money then going into the new Roth account. Thus, a conversion will generally trigger a current federal income tax bill (and maybe a state income tax bill too). But the following positive factors may outweigh the current tax hit:

The tax hit that is triggered by your conversion is reduced if the value of your traditional IRA has been beaten down by stock market losses.
Today’s tax rates may be the lowest you will see for many years. Assuming that is true, converting would allow you to completely avoid higher future federal income tax rates on the entire post-conversion increase in the value of your Roth account.

The Roth conversion privilege is not available to everyone this year. For 2009, it’s available only if your modified adjusted gross income (not including any additional income triggered by the conversion itself) will be $100,000 or less.

But for 2010, the $100,000 restriction is scheduled to be lifted, which will allow every owner of a traditional IRA to take advantage of the Roth conversion strategy, regardless of their income. If your income level prevents a 2009 Roth conversion, you can do one in 2010.

Either way, there is no limit to the account balance that you are converting.

Reversing a Conversion. Another great thing about the Roth conversion strategy is that you can change your mind. You have until October 15 of the year following the conversion year to recharacterize (unwind) your converted account (or accounts). For example, say you convert two traditional IRAs into Roth accounts in early 2010. Later next year, the values of the converted accounts plummet due to poor performance of the investments held in the accounts. In this bleak scenario, you would pay 2010 income tax on value that later disappeared.

Thankfully, you have until October 15, 2011, to recharacterize the two converted accounts back to traditional IRA status – as if the ill-advised conversions never occurred. As a result, you won’t owe any 2010 income tax on the now-unwound conversions.

Conclusion. Two conditions make this a good time to convert your traditional IRA to a Roth:

the low current tax cost for converting, and
the chance to avoid higher future tax rates on income and gains that will accumulate in your Roth account as the economy recovers.

Because there are a number of variables to consider that we have not discussed here, before you pull the trigger please contact your Schmidt Westergard & Company tax professional.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.