Ask Money

A smart time for a Roth conversion

Chris Farrell Sep 14, 2011

Question: On Marketplace Money, you often say it’s a good idea to have a Roth IRA. What do you think of the idea of a Roth conversion, rolling a SIMPLE/SEP IRA or a 401K into a Roth IRA? I know you have to have the $$ on hand to pay the taxes right away. I’m betting tax rates are heading upwards before long, particularly on the upper brackets. Seems like a good time to lock in taxes at the lower rates now and build up a tax free nest egg to me. (I also think that Roth conversions can happen even if one’s income is above the max income threshold that would keep one from contributing to a Roth directly.) Jim, Royal Oak, MI

Answer: It could be a good move on your part. I like the Roth-IRA, although in general I worry that the financial benefits of a Roth conversion have been way oversold. My bottom line is to make sure it’s the right financial move for you at this time of your financial life.

There are a lot of imponderables to consider, such as the likelihood of higher tax rates in the future versus lower tax rates with comprehensive tax reform. (I still lean toward the latter since I don’t see how else we will get compromise legislation on bringing down the federal debt and deficits.) You also need to make a guesstimate on your income and tax bracket during retirement. The higher your income later in life the more attractive the tax-free withdrawals are from the Roth–and vice versa.

There are a number of other benefits to a Roth besides tax-free withdrawal in retirement. For instance, there is no required minimum distribution at age 70 ½ as there is with a regular IRA. The annual income limits on Roth contributions don’t apply with a conversion. You’re right about that.

You’re also right that it’s critical to have other savings on hand to pay the tax bill–you don’t want to tap into the pre-tax retirement money for it. You also need to figure out whether paying taxes upfront is the best use of your savings compared to, say, maintaining a flush emergency savings account. Assuming you do have savings and you decide conversion is a good use of your savings, the argument for converting strengthens the longer your money can compound before retirement.

By the way, you can convert directly from a 401(k) and similar employer-based retirement plans into a Roth so long as you’ve left your employer. In general, the rule is if you have an active retirement savings account at work you can’t convert it into a Roth. However, if you’re over 59 ½ and still working at your company you can withdraw without penalty the money in your employer’s defined contribution pension plan and place it in a Roth. Your company’s pension plan document must allow for such an “in-service” distribution.

A good conversion calculator is at analyzenow.com. Check it out.

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