SPECIAL REPORT

TO CONVERT OR NOT TO CONVERT

Considerations for Converting a Traditional IRA to a Roth IRA

by Daniel J. Pilla

Executive Director, Tax Freedom Institute

Published by Winning Publications, Inc.

Do you have a traditional IRA? Have you ever wondered whether it would be advantageous for you to convert your traditional IRA to a Roth IRA? Are you considering establishing an IRA? If you’ve answered yes to any of these questions, then read this article carefully. What you learn here could save you countless thousands of dollars in taxes between now and the time you retire.

Key Differences Between a Traditional IRA and a Roth IRA

People generally know that there are certain advantages to a so-called Roth IRA over those of a traditional IRA. Here are some of the differences:

· Roth IRAs provide for tax-free growth. Traditional IRAs provide only tax-deferred

growth.

· Roth IRAs are more flexible than traditional IRAs because Roth’s have no age requirements for when you must stop making contributions or you must start taking distributions.

· The income phase-out limits are higher for Roths than they are for regular IRAs.

· Earnings in a Roth can be transferred to beneficiaries income tax-free but beneficiaries must pay income tax on inherited traditional IRAs.

· You have more flexibility in withdrawing money from a Roth because all contributions are withdrawn tax and penalty-free before earnings.

The Roth is a Tax-free Savings Vehicle

The major difference between a Roth and a traditional IRA is that contributions to the Roth are not deductible, while contributions to a traditional IRA are deductible (within limits). On the other hand, qualified distributions from the Roth are not taxed (hence, they are tax-free), while distributions from a traditional IRA are subject to income tax at current rates (hence, they are tax-deferred).

The contribution portion (the money you put in) of a Roth is never subject to tax upon withdrawal. This is because there was no deduction allowed for the contribution in the first place. In order for the earning’s portion to qualify as a tax-free distribution, the earnings must be held in the Roth for at least five years, beginning on the first day of the first year for which the contribution was made, and one of the following factors applies,

· The distribution occurs when you are at least 59½ years of age,

· The distribution is due to death or disability, or

· The distribution is made to you as a qualified first-time homebuyer.

Keep in mind that distributions of your contribution amounts are never taxed and never subject to the 10 percent penalty for early withdrawal.

Should I Convert My Traditional IRA to a Roth?

It is for these reasons that many people take advantage of the conversion provisions of the law. These provisions allow a person to take a distribution from their traditional IRA in order to fund a Roth.

There are a number of factors to consider in making the decision to switch existing funds to a Roth. The first and perhaps most important is that your distribution from the existing traditional IRA is a taxable distribution. That means you must report as ordinary income any amount to take from your traditional IRA, even if it’s immediately rolled into the Roth.

In addition to that, you may be subject to the 10 percent penalty on the distribution if you don’t meet any of the IRA penalty exemption rules, chief among them that you must be at least 59½ years of age at the time of distribution.

So why would one convert a traditional IRA to a Roth, only to bear the burdens of the income tax on the distribution? The answer is that provided you meet the conditions discussed above, you are not taxed on the income earned by the account over time.

But that, standing alone, does not mean you should convert to a Roth. You have to balance several competing factors. Here are some of the key factors to consider:

1. Your income in the year of the conversion. Roth conversions can be done only by those with modified adjusted gross income of less than $100,000 in the year of the conversion. This figure does not include the amount of income attributable to the IRA distribution. If you don’t qualify in a given year, you’ll have to reconsider your conversion plans.

2. Your present age. Conversations to a Roth strongly favor younger citizens. The reason is that a younger person has more time to recover the tax hit through market gains over time. The closer you are to retirement age, the less time you have to make up the ground. Suppose you’re 40 years old and you have $25,000 in a traditional IRA. Suppose your effective tax rate is 30 percent. By taking the distribution, you incur federal and state income taxes (but no early withdrawal fee as discussed below) of $7,500.

Assuming only a modest return on your investment of 7 percent annually, it will take less than six years to recover the $7,500. Now, at age 46, your investment regains its pre-distribution value and further distributions would be free of both tax and penalty. By the time you’re ready to retire at, say age 65, you enjoy 19 years of tax-free and penalty-free growth on your savings.

3. Your investment behavior. If you are a very conservative investor, you must factor this into your cost/benefit analysis. I used an example of 7 percent growth in the above discussion, but many people just don’t risk their money. They may invest in money market holdings or very conservative bond holdings. If this is you, you must carefully figure where you’re going to be in terms of growth by the time you’re ready to retire. Regardless of your age, you may not be able to make up the ground.

4. The status of the market. Because you have to pay taxes on the conversion, you must take into account the status of the market. If we’re in a hot bull market, it may take less time to recover the tax loss than it would in a bear market. Consider this factor along with point number three above, regarding your investment behavior. For example, it may not make any difference that the market is hot if your investment attitude is excessively conservative.

5. The size of the conversion. Under our graduated income tax system, the larger the withdrawal, the more costly the conversion. This is especially true if your withdrawal pushes you into a higher tax bracket. For example, in 2006, the 25 percent bracket for married filing jointly runs from $61,300 to $123,700 of taxable income. Suppose you and your spouse have taxable income of $90,000. That means you can take up to $33,700 of IRA distributions without being pushed into the 28 percent bracket. Anything over that, and you pay at the higher rate.

This means that you must consider the size of your distribution before rushing headlong into a conversion. If a single distribution will push you into a higher bracket, consider using multi-year distributions. Suppose, for example, you have an IRA worth $150,000. Taking the entire distribution in one year will create a substantial tax hit and push you into a higher tax bracket. You can minimize the bite by making smaller conversions, say $50,000 per year over three years, or $30,000 per year over five years.

6. Immediate need for the money. Many people think in terms of the Roth IRA as a means of getting immediate access to retirement funds without any risk of the 10 percent early withdrawal penalty. And while it’s true that initial Roth investments may be taken tax and penalty-free at any time, that is not so with gains or with conversion assets.

In the case of gains, any distribution that does not meet the conditions discussed above, under the heading, “The Roth is a Tax-free Savings Vehicle,” are subject to current income taxes. In the case of conversion assets, they are subject to the 10 percent penalty unless you meet the rules for avoiding the penalty, which are discussed below.

For these reasons, you cannot look at conversion assets as being immediately available for your use without regard to the early withdrawal penalty.

Avoiding the 10 Percent Penalty on Early Withdrawal

As discussed above, there are potentially three types of Roth assets. They are, 1) original contributions, 2) conversion assets, and 3) investment gains. Let’s discuss each one as it relates to the 10 percent penalty for early withdrawal of Roth assets.

1. Original contributions. As stated above, the original contribution you invest in a Roth account is never subject to either taxes or the early withdrawal penalty. Suppose you put $5,000 in a Roth at age 40 and two years later, the account is worth $5,400. You withdraw $5,000 at that time. You are not subject to any income tax or penalty on the withdrawal because your withdrawal did not exceed the amount of the original contribution.

2. Conversion assets. Conversion assets are those that come into a Roth by converting a traditional IRA. In order to avoid the penalty on distributions of conversion assets, you must hold those assets in the Roth for at least five years, beginning with the year in which the conversion was made. Once this holding period has passed, you can withdraw conversion assets (but not investment gains) without risk of the 10 percent penalty.

Please note that each conversion amount has its own five-year holding period. For example, suppose you convert a $150,000 traditional IRA into a Roth over a three-year period. Each $50,000 conversion is subject to its own five-year holding period, beginning with the year of the particular conversion.

3. Investment gains. Whether investment gains are subject to the 10 percent penalty is based upon the same rules that determine whether they are taxable. In other words, the distribution of gains is subject to the 10 percent penalty if the gains are subject to income tax. See the discussion above, under the heading “The Roth is a Tax-free Savings Vehicle,” for the conditions under which a distribution of gain is subject to tax, and therefore penalty.

As an example, suppose you contribute $5,000 to a Roth at age 40 and two years later, the account is worth $5,400. You withdraw the entire $5,400 at that time. Withdrawal of the initial investment is free of tax and penalty. However, you are taxed on the $400 and are subject to an early withdrawal penalty of $40.

Please also note that the five-year holding period for gains is subject to a separate calculation than the conversion holding period. Suppose you convert $5,000 to a Roth in year one. By year six, you can take the $5,000 free of tax and penalty. But suppose that in year three, investment gains of $400 are credited to the account. These gains are not subject to a tax and penalty-free distribution until year eight.

The penalty is also avoided if any of the conditions of code section 72(t) apply. This provision establishes the general exceptions to the early withdrawal penalty, such as in the case of a first-time homebuyer, a period of unemployment, etc.

Get Help Before Converting

You must do some careful planning before making the decision to convert your traditional IRA to a Roth. You can get help by calling my office at 800-346-6829, or by contacting the Tax Freedom Institute member nearest you. Just call the member nearest you to discuss how they might help you in your situation.

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