Usually the days around April 15th are the last time you would want to consider sending even more money to Uncle Sam than you otherwise already owe.
But now may be a great time to convert your IRA to a Roth IRA. Yes, you’ll incur taxes on the converted amount now. Yet the long-term gain of such a move could far exceed the short-term tax pain you might pay today.
The conversion
The IRS allows IRA owners to convert some or all of the IRAs to Roth IRAs at any time, with two main restrictions. The first is that the money converted will be taxed as ordinary income (but with no other penalties, regardless of age).
The second is that your adjusted gross income must be less than $100,000 in the year in which you make the conversion. That limit is the same whether you file single or married-jointly, but doesn’t include the converted amount.
So if your income is below the limit, and you’re in an overall tax bracket of 25%, converting $10,000 of your IRA will cost you an extra $2,500 in taxes, usually due by the April 15th of the year after you make your conversion.
“More taxes? Count me in!”
Okay, the prospect of a bigger tax bill today doesn’t sound that appealing. But keep in mind that the taxes you pay now could be the last taxes you or ever pay on the converted amount.
The savings could be substantial. Say your $100,000 unconverted IRA grows at a hypothetical annual rate of 8% per year over the next twenty years, after which you will retire and withdraw the balance over the twenty years after that.
If you’re in the same 25% tax bracket during retirement and you don’t convert now, you would pay $200,000 in taxes on the amount during retirement, versus the $25,000 you pay to convert it to a Roth IRA right now.
Plus, Roth IRAs hold several advantages over IRAs during retirement, including no mandatory distribution age, as well as the fact that Roth IRA withdrawals not increasing taxation on Social Security payments.
Why now
Two factors make this an ideal time to consider converting an IRA to a Roth IRA. The first one is that since your IRA account value is likely to be on the low side right now, any taxes paid on a converted amount will also be lower than what they otherwise might be.
The second reason to do it today is if you think that you will be in a higher tax bracket during retirement than you are when you make the conversion.
Now, most people are usually in the same or lower bracket in retirement, so a conversion may not make sense while you’re still working.
But can you imagine a scenario where state and federal governments raise the tax rates in the future, snaring your retirement income with a higher rate? I can, too—pretty easily, in fact.
Who should do it
So besides an income that falls under the $100,000 limit, optimism that retirement account values will be higher in the future, and pessimism that your tax rates will be as well, there is one other requirement that should be in place before you consider conversion.
Ideally, you will have enough money outside of your IRA to pay the extra tax bill, so that you won’t have to take more out of the IRA just to pay the taxes—which requires incurring more taxes, so you then have to take more out of the IRA, and so on.
Sooner rather than later
Even if you meet all the qualifications described above, you may still be hesitant to make the conversion now, seeing that your IRA account values (and therefore, the taxable amounts) might go lower still in the near future.
The IRS provides some good news along those lines, because if you make the conversion now and a subsequent drop in values makes you wish you had waited, you have up until April 15th of next year (2010) to “recharacterize” the conversion at the new, lower value (with a new, lower tax bill).
The window for the “do-over” can even be extended to October 15th
of 2010, if you’re willing to file for an extension. But you do only get one chance at another chance to recharacterize the conversion.
So it’s usually best to make the switch now, and hope that prices rise and never come back. But if you’re wrong, at least you’ll get a chance to hedge against the uncertainty of the markets.
What you will know for sure, is that you’re done paying taxes on whatever amounts you convert.
