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Winter 2010


Traditional IRA: Shall I Convert?

Scott Thompson and Jon Koteski, CFA
Oakmont Capital Management, LLC, Oakmont, PA

As a result of legislation passed under the Bush administration, the $100,000 gross income limit for an individual to convert a traditional individual retirement account (IRA) to a Roth IRA will be lifted in 2010. As a result, regardless of gross household income level, you will be eligible to convert your IRA to a Roth IRA. The only question is “Shall I convert?”

Before discussing the reasons “why” or “why not,” let’s review the elementary differences between a traditional IRA and a Roth IRA. Even though both are forms of a retirement account, they have their own distinct characteristics.

With a traditional IRA, pre-retirement contributions can be tax-deductible. The tax-deductibility is dependent on the individual’s income level and the availability of an employer-sponsored retirement plan for the spouse. The assets within a traditional IRA grow tax deferred until withdrawn at retirement. Each withdrawal is subject to federal income tax. Conversely, contributions to a Roth IRA are made with after-tax money. There is no tax deduction for the contribution. Like a traditional IRA, the assets grow tax deferred until retirement. However, because contributions are made with after-tax money, the withdrawals at retirement are not taxed. This in a sense makes a Roth IRA a tax free retirement asset.

The traditional IRA also has required minimum distributions (RMD) beginning at the age of 70•. Once you reach this age, you are required to withdraw a certain percentage of the account value on an annual basis and pay the associated federal income taxes. The Roth IRA on the other hand has no RMD and any withdrawals are tax-free. As noted, this is due to the contributions of a Roth IRA being made with after-tax money.

When deciding to convert a traditional IRA to a Roth IRA, you need to consider multiple factors. Many people mistakenly believe, given the opportunity, they should convert. They assume they will be better off having a tax free asset at retirement in the form of a Roth IRA than they will with a taxable asset in the form of a traditional IRA. To make the correct decision, people should consult their tax advisor and be cognizant of the following:

Current Income Tax Rate vs. Expected Income Tax Rate at Retirement:

All other things being equal, the rule of thumb is if you believe your income tax rate at retirement will be less than your current income tax rate, you should not convert. This is because when you convert, you pay income taxes on the total market value of the traditional IRA in the year in which you convert. Consider the following example. Dr. Tom, an anesthesiologist with 25 years of experience, currently has $100,000 in a traditional IRA, and his federal income tax rate is 30%. If he converts to a Roth IRA, he will pay $30,000 in federal income taxes this year due to the realization of $100,000 in taxable income. If Dr. Tom leaves the $100,000 in the traditional IRA and doesn’t convert, he will pay taxes when he takes distributions at retirement. If at this time his tax rate is 20%, he will pay 20 cents in federal taxes on every dollar he withdraws. This lower tax profile suggests it may not be beneficial for him to convert today.

Conversely, if Dr. Tom is a young resident and just beginning his career, it may make sense for him to convert. This is because there is a good chance his current tax rate may be less than what it is going to be when he retires. But obviously, there is no guarantee.

Ability to Pay the Additional Income Tax Associated with the Conversion:

If you do not have the excess cash to pay the additional taxes generated from the conversion, it may not be feasible for you to convert. If you use cash from your traditional IRA to pay the additional tax, you may also be subject to a 10% penalty due to it being an ineligible withdrawal. This penalty is in conjunction with any taxes generated. Furthermore, the conversion may put you in a higher tax bracket, especially if you file jointly and both you and your spouse decide to convert. It may make sense to only convert an amount that will permit you to remain in your current income tax bracket or develop a plan in which you do a multi-year conversion with manageable dollar amounts each year. For calendar year 2010 only, if you convert, you can spread the realized taxable income over 2011 and 2012.

Estate Planning:

For certain estate planning purposes, a Roth IRA may be more attractive relative to a traditional IRA. Assets of both transfer to the beneficiary tax deferred, however, the beneficiaries of a Roth IRA do not have to pay federal income taxes on future withdrawals regardless if they are retired or not. This is not the case with a traditional IRA. As result, a Roth IRA is a simple way of transferring an income tax-free asset to a spouse or heir. Secondarily, the value of the estate is reduced by the income paid due to the conversion. This lowers the overall estate tax liability at death.

Stock Market Dynamics:

Since the tax liability of the conversion is directly related to the market value of the assets of the traditional IRA, it advantageous to convert when asset values are depressed. This usually occurs during or after a market crisis, similar to one we experienced in 2008 and the first part of 2009. It is especially attractive if you have a significant amount of time until retirement and you can benefit from multiple market cycles through a proper investment strategy.

Re-characterization:

If you convert today and an exogenous event occurs preventing you from having the means to pay the additional tax liability, the IRS will allow you to “unconvert” or re-characterize your Roth IRA back to a traditional IRA. You can do this up until you file your tax return for the year in which you initially converted. You may also consider re-characterizing if the market value of your Roth IRA assets drops significantly after the conversion. This will allow you to convert in the future at a more attractive market value.

“How does the actual conversion process work?” Relatively, it’s quite simple. It’s no more difficult than opening a typical brokerage account and transferring assets into it. Some brokerage firms will even allow you to do the conversion online. If you already have a Roth IRA in place, you may not even need to open a new account. You can refer to IRS Publication 590 for more details on the intricacies.

“Shall I convert?” is not an easy question to answer. There are many factors that weigh into the decision. Some have been discussed in this article and others have not. An improper decision or assumption regarding these factors can significantly affect the amount of assets you have at retirement. Do your homework and consult your tax and investment advisors prior to walking down the conversion path. Converting may not always be in your best interests...


You may e-mail the authors at sthompson@oakmontcap.com and jkoteski@oakmontcap.com Sources: The Vanguard Group, Inc. Morningstar, Inc. BlackRock, Inc.