While there are many ways to save for retirement, one of the most basic is the traditional Individual Retirement Account (IRA). In a traditional IRA, the money contributed is generally done on a pre-tax basis with any earnings being tax deferred. When withdrawn, it is typically subject to taxes at that time.
However, an investor can choose to pay the taxes now on his or her IRA by converting this money to a Roth IRA.
The first major decision point is to determine if you should even consider this. After all, why would one choose to pay taxes earlier than needed? First, the growth within the converted Roth IRA is completely tax-free assuming you distribute the Roth IRA after age 591/2 and once you have had any Roth IRA open for at least 5 years. Additionally, there are no required distributions from a Roth IRA beginning at age 701/2 as there are with traditional IRAs.
Once you decide that this could be a good move, you have to make various assumptions before moving forward. The biggest factor is the current and future tax rate environments. If you assume that you will be in a higher tax bracket in future years, it may make sense to convert the IRA and pay taxes at today’s rate versus allowing the traditional IRA to grow and pay taxes on the future distributions at a higher rates. Also consider the expected growth of the account. Once converted, any future growth is generally tax-free. If you expect the account to grow significantly, the more palatable a Roth conversion appears. Another factor is time. The longer the money stays in a Roth IRA, the more you should lean towards conversion because the tax-free growth can compound for a longer period of time.
The last major consideration involves paying the actual taxes due upon the conversion. If you can’t pay the taxes due on the conversion from your checking, savings or other after-tax funds, then you should not consider this.
Lastly, consider the ability to recharacterize this decision. You have until the tax deadline, including extensions, of the year following the conversion to recharacterize it. In other words, for 2012 conversions, you can decide through Oct. 15, 2013, whether you want to keep this and pay the taxes or undo it and assume it never happened. This is a simple process but it creates a cumbersome tax filing.
While the above sounds simplistic, this is truly an area where you should consult with a qualified tax and financial adviser. For me, I am a firm believer in Roth conversions while many others in my field are not. This is truly an art and not a science as the assumptions used and the client’s circumstances will determine whether this is a good idea. Nevertheless, it should always be discussed with qualified professionals to make a decision that is best for you.
Life is a journey, plan for it.
Neil A. Brown is a CPA and CFP with Burkett Financial Services in West Columbia. Reach him at uscneil.com or (803) 200-2272.