Tom looked at his Traditional IRA account balance and sighed. He had been saving faithfully for more than 20 years, making the maximum possible contribution each and every year. His mutual funds had performed admirably, averaging about 12% growth per year over time. He has a balance of more than $160,000, and retirement is only a few years away. Tom wishes he could convert his Traditional IRA to a Roth IRA, but his current level of income prevents him from doing so. He also dislikes the idea of having to take a required minimum distribution (RMD) every year, because he's afraid that the additional income might cause some of his Social Security income to become taxable.

When deciding whether to covert an IRA many different factors must be considered. Read on to learn what you need to know to weigh this decision for yourself.

Timing Is Everything - Or Is It?

For many investors, converting now is usually a good idea. For example, if an investor with a $20,000 Traditional IRA makes $40,000 a year now and expects to have only $25,000 a year of income in retirement, he or she will probably be wise to go ahead and convert the IRA now and allow the tax-free growth to accumulate over time. However, this general rule applies only to low or middle-income investors with smaller Traditional IRA balances. Large Traditional IRA account holders may or may not benefit from waiting to convert.

Example - Roth IRA Conversions and Tax Consequences
If Tom makes $40,000 a year and converts his Roth IRA, he can only convert a small portion of it each year if he wants to avoid a higher tax bracket. Of course, he could also convert his Roth IRA in small portions after he retires, but the additional income generated thereof could trigger taxation on a portion of his Social Security income. Investors who are close to retirement should think carefully about whether they want to convert at this point and should probably consider designing a comprehensive financial or retirement plan that accounts for all possible variables and contingencies in order to see which path is best.

Make Those Losses Work For You
Various tax credits and deductions can also be affected by the income realized from a Roth conversion. For example, a family with $30,000 of income that qualifies for the Hope or Lifetime Learning Credit may become ineligible after the income from a Roth conversion is added onto his or her Form 1040 (tax return). However, if the family owns a business that posts a net loss of $75,000 for the year, then they will become ineligible for any nonrefundable credits of any kind. Therefore, a Roth conversion could be just the thing to bring the family's income for the year back into the black. If Tom were the husband in this family, he could conceivably convert his entire Roth IRA balance in one year and only declare $85,000 of it as taxable income. Of course, he could convert a lesser balance as well if he wants to keep his income low enough to qualify for the education tax credits. But losses of various kinds can be used to offset Roth conversion income, including:

  • Net operating loss (NOL) carry-forwards
  • Charitable contribution carry-forwards
  • Nonrefundable tax credits
  • Deductions and exemptions in excess of income
  • Business and other ordinary losses

As long as the loss is not considered to be passive - meaning that it can only be offset against passive income - it can be used to offset the income from a Roth conversion. Charitable-minded donors can also employ a similar strategy as the family with the business loss for their carry-forward deductions. Consider a donor who gives $100,000 of stock to charity and ends up having to carry forward $50,000 of the deduction because his or her current deduction exceeds the adjusted gross income (AGI) threshold limitation. The $50,000 carry-forward deduction can be applied against income from a Roth conversion just like the business loss in the previous example.

Other Considerations
Estate planning can also be a factor in determining whether to convert to a Roth IRA. If you are planning to leave your Traditional IRA entirely to heirs and have no need to take distributions from it now, then converting is probably a good idea. This will prevent your heirs from having to take RMDs all of their lives and can reduce your taxable estate as well. In fact, converting to a Roth IRA is virtually always a good idea if estate taxes are an issue, as Traditional IRA holders can end up having to pay estate taxes on money that will only be used to pay income taxes at some point! For example, a taxpayer with a $1 million Traditional IRA who is facing estate taxes will have to pay estate tax on the entire million dollars, even though at least a third of that amount will likely go to pay the income taxes on the distribution. But if he or she were to convert to a Roth before death, then only the after-tax remainder will be subject to estate taxes.

Before you can know whether you should convert your Traditional IRA to a Roth IRA, you must carefully examine several variables, including both your present and estimated future tax situation, as well as your income and cash flow objectives. Traditional IRA owners, especially those with higher incomes and larger balances, should consult their tax advisors for further assistance with this matter.

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