Last week, we talked about Roth IRAs and why they are good investment vehicles. Today, we’ll talk about Roth IRA conversions.


The biggest issue in a Roth IRA conversion is tax. Since traditional IRAs are usually funded with tax deductible contributions, when you distribute the money from the IRA, you will owe income tax on it. The same goes for conversions. Since you are converting those funds into an after-tax Roth IRA, you must pay income tax on the amount you convert. This is a consideration that must be carefully reviewed before you decide to make any conversions.


Who Shouldn’t Convert

If you are in the following situations, converting your traditional IRA to a Roth IRA probably isn’t a good option for you.


  • If you don’t have enough cash on hand to pay the tax – There are two options for paying the tax on a 2010 Roth IRA conversion: pay 100% of whatever tax you owe in 2010, or pay half in 2011 and half in 2012. Splitting the tax over the next two years will help to alleviate some of the pain of parting with your money, but if for any reason you don’t believe you will have enough cash to cover the taxes, don’t make the conversion. In other words, if the only way you’ll be able to pay the tax is by withdrawing the funds from the portfolio, it’s not worth doing.


  • If converting pushes you into a higher tax bracket – If $15,000 of additional income will take you into the next highest tax bracket, and you are thinking about converting a $20,000 IRA, you’ll be paying additional dollars in taxes due to the higher rate. However, if conversion fits your needs, you can convert part this year and part next year to avoid paying at a higher tax rate.


  • If you know your tax bracket will decrease – If you want to convert, but expect a decrease in income over the next few years, that will bring you into a lower tax bracket, it probably makes sense to wait. That way you can still convert the money and pay less in taxes.


  • If you plan on leaving the funds to a charity – If you plan on leaving your IRA to a charity after your death, you should leave the money in a traditional IRA. The charity will receive the money from the IRA tax-free, so it doesn’t make sense for you to convert to a Roth.


People who should consider converting

Here are some situations where conversion to a Roth IRA might make sense.


  • If your tax bracket will be increasing – As the opposite to the tax bracket point above, if you are expecting to be in a higher tax bracket in the future and are interested in converting, you should do it now to avoid paying more tax (if you can currently afford the tax and it doesn’t push you into a higher tax bracket!).


  • If you don’t need the Required Minimum Distributions (RMD) – If you don’t anticipate needing to take the RMD from your traditional IRA account at age 70½ for income purposes, converting to a Roth may be a good move. You can protect your account balance by letting it grow undisturbed by yearly RMDs, and you will still have access to the money should the need arise, but you’ll get it tax-free!


  • If you plan on your IRA being inheritance for your heirs – A Roth IRA will provide a better inheritance vehicle because your heirs will receive the money income tax free. If you are thinking about your IRA as more of an estate planning tool, another consideration should be what tax bracket your heirs will be in. If they will be in a higher tax bracket than you when they inherit an IRA, they will be paying income tax on the distributions. You may want to consider converting to pay the taxes now so your heirs can have an income tax-free inheritance.


We just want to emphasize again that the tax consequences of a Roth IRA conversion should be carefully considered before making a move. If you have questions or need help figuring out the taxes on a conversion, talk to a tax professional.