To Convert or Not to Convert ... to a Roth IRA

by Judy Dahl

Experts agree that an IRA (individual retirement account) is an excellent, tax-advantaged vehicle to use for retirement savings. But which is better for you, a traditional or a Roth IRA? If you have a traditional IRA now, should you convert it to a Roth?

"Generally the Roth will be better," says Dennis Zuehlke, compliance manager, IRA Services, at CUNA Mutual Group, Madison, Wis. "But it really depends on your situation."

Contributions to a traditional IRA are tax-deductible for many taxpayers, but most distributions from the account are subject to income tax. You're required to start taking distributions from the account at age 70 �.

With a Roth IRA your contributions are never tax-deductible, but you may qualify to receive tax-free distributions from the account. There's no mandatory distribution age, and if the account has been open for five years, you can begin withdrawing tax-free earnings at age 59 � (see sidebar for more information).

"The difference is, with a traditional IRA you may be able to get a tax deduction up front but you pay taxes on the way out. With a Roth there's no tax deduction up front, but you can avoid paying taxes on the way out," says Zuehlke. "It depends whether the tax-deductible contributions up front or the tax-free earnings later on are more important to you."

Are you eligible to convert?

Your future tax bracket

If you think your tax rate will be the same or higher when you retire, it may make sense to pay the taxes now--you pay income tax on the rollover--and convert to a Roth IRA with its tax-free growth and earnings. This can significantly increase the value of your retirement savings over time.

Converting to a Roth also may help you avoid paying taxes on benefits such as Social Security during your retirement. If your AGI is high enough these benefits are taxed. Distributions from a traditional IRA are included in your AGI, while Roth IRA distributions are not.

If you'll be in a lower tax bracket at retirement, it may not make sense to pay the taxes due as a result of the conversion today. "In this case you'd likely be better off staying with your traditional IRA and paying the lower taxes when you take distributions," says Zuehlke.

However, he notes, it's difficult to predict future tax rates. He suggests using one of the many calculators available online to estimate your IRA's value under different scenarios and to compare traditional and Roth accounts side-by-side.

Your estate

Conversion timing

Carefully consider the timing of a conversion. Most people benefit from converting traditional IRA funds to Roth IRA funds as early as possible. This maximizes the amount of tax-free earnings that will eventually be received from the Roth IRA after retirement. But you also should consider spreading a large conversion over several years to avoid having to pay income tax at higher tax rates and to avoid paying the alternative minimum tax. You generally are required to pay income taxes on the amount you convert in the year the money leaves your traditional IRA. The main exception is that you are not required to pay income tax on the return of your traditional IRA basis that you created by making nondeductible contributions to your traditional IRA.

Also consider how many years you have until retirement. The more time until your retirement, the more advantageous it usually is to convert to a Roth. You'll have more time for your earnings to make up for what you paid in taxes.

Can you pay the taxes?

It's important to pay taxes on your conversion amount from non-IRA funds. "If you use IRA assets to pay the taxes, you'll generally pay a 10% early-withdrawal penalty if you are under age 59 �," says Zuehlke. "You'll also lose the opportunity for tax-free earnings on the portion not converted to a Roth. These costs probably will outweigh the benefits of the conversion."

And since your conversion amount is included in your income for tax purposes, it's possible that this amount could push you into a higher tax bracket. This could disqualify you from other tax benefits such as the dependent child credit.

A partial conversion

What if you change your mind?

If you find that you've made a mistake with your IRA conversion--for example, if your household income ends up exceeding $100,000--you can "recharacterize," or undo your conversion, and convert the money back to a traditional IRA.

Then you won't have to pay taxes on the conversion amount. If you've already paid the taxes, you can file an amended return and get a refund.

You even can recharacterize if the stock market--and therefore the value of your portfolio--drops after you've converted to a Roth and paid taxes on the higher portfolio value. You have until at least your tax return deadline for the year in which the money left your traditional IRA to recharacterize.

You can choose to convert to a Roth IRA again, but not in the same tax year as your original conversion and recharacterization. The recharacterized funds must stay in your traditional IRA at least 30 days before converting again.

With this feature, Bruce calls a Roth conversion "a mistake-proof proposition."

Getting started

To get started, you'll want to consult a tax adviser to ensure you're eligible for a Roth conversion and that it's in your best interests from a tax standpoint. Then your credit union IRA representative can help you through the conversion itself.

"On the three-legged stool of retirement savings sources--Social Security, pensions, and personal savings--two of the legs are getting wobbly," says Zuehlke. "There's more and more emphasis on personal savings, and an IRA's tax advantages are undeniable." A Roth IRA may just be your best bet.

June 12, 2006