Blog Article

Roth IRAs: To convert or not to convert

By Merriman Wealth Management, Wealth Advisor
Published On 01/04/2010

As a financial advisor and CPA, I often receive tax questions from my clients.  One that has been coming up a lot in the past year is: “Should I convert my non-Roth retirement plan (401(k), traditional IRA, 403(b) or 457(b)) to a Roth IRA?”  The question isn’t surprising, given the new rules that took effect January 1 for Roth IRA conversions.

The short answer, which should not surprise you, is: “It depends.”

The issue is complex, and the answer for one person can be radically different from the answer for someone else. Converting might be a boon, a mixed bag or a mistake, all depending on your circumstances.

It’s worse than that, because the only way to make sure you’re making the right choice is to know some variables of the future which simply cannot be known.

My bottom-line advice is to seek professional advice from your tax advisor, your financial advisor or your tax attorney before you take the plunge.

A word of caution

The difficulty with Roth conversions, like the difficulty for many tax strategies, is that the right answers cannot be known in advance. You usually cannot know your future income for sure. You cannot know what Congress will do to the tax code. And you cannot know future tax rates. In each case, the best you can do is guess.

We can analyze potential outcomes until we’re blue in the face, but the fact remains that the future is never certain.

Let me also say upfront that as a tax accountant, I’m trained to help clients find ways to defer taxes.  A Roth conversion turns that approach on its head by purposely accelerating tax payments.  And once a conversion is done, it cannot be undone except within a short window of time, generally only until the extended due date of the tax return for the year in which the conversion occurred. Therefore, you should be very comfortable with the tradeoffs of a Roth conversion before you do it.

Roth IRA basics

Most people are familiar with traditional IRAs: contributions are generally tax-deductible, the earnings grow tax-deferred, and distributions are taxed as ordinary income in the year of withdrawal.  In a traditional IRA, the owner must, beginning at age 70 ½, make mandatory withdrawals called required minimum distributions, or RMDs. By contrast, Roth IRA contributions are not tax-deductible. But there is no tax on earnings in the account and withdrawals are tax-free as long as the owner meets certain requirements.  Roth IRAs are not subject to RMDs.

From a tax perspective, traditional IRAs let you save on taxes now and pay taxes later, presumably at a lower tax rate after retirement. Roth IRAs require you to pay taxes now, but you get to earn tax-free (not just tax-deferred) income in the account.

Roth conversion basics

When you convert a traditional IRA into a Roth IRA, you must pay taxes all at once on the whole amount that you convert. This isn’t something most people are eager to do. And until now, Roth conversions have been restricted to taxpayers with modified adjusted gross incomes of $100,000 or less.  This has blocked many people from converting.

New rules for 2010 and beyond

Starting in 2010, the income restriction on Roth conversions will be repealed. An article in the Journal of Financial Planning suggested that more than 13 million investors would become eligible for Roth conversions for the first time in 2010.

Congress also included a special bonus for taxpayers who convert in 2010: They can choose to defer the tax effect of the conversion to the years 2011 and 2012. (As the law stands now, this affects only 2010 conversions, not those made later.) On the surface, this seems like a pretty good deal: Get the benefits of a Roth IRA now and pay the taxes later.  Unfortunately, it’s not quite that simple.

TIDE: Taxes, Inheritance, Diversification and Estate planning

When I help clients decide if a Roth conversion makes sense for them, I try to cover four areas: taxes, inheritance, diversification and estate planning.  I call this my “TIDE” analysis.  No single factor will control the decision, but taken together these four factors can give clients a reasonable handle on the pros and cons for their situation.


Taxes are often the driving factor for most people who consider Roth conversions.  Unfortunately, it’s also the most complicated variable to predict accurately, because the outcome depends on income and tax laws, either of which can change drastically.

Generally speaking, you are likely to benefit from a Roth conversion if you will be in a higher tax bracket when you withdraw money from the account. You can pay taxes at your current (lower) rate and avoid taxes later at the higher rate you anticipate. You can manage your tax exposure through partial conversions over multiple years so that you don’t have too much additional income in one year and bump yourself into a higher tax bracket.

Why might you be in a higher tax bracket when you begin to draw on your IRA assets?  For one thing, you might have higher income in retirement that could move you into a higher tax bracket. For another, Congress can always raise tax rates.

Most of us who are currently working are unlikely to have more income in retirement than we have now. This makes us poor candidates to consider conversion based on tax savings alone.  But those who are not presently working or are retired and on fixed incomes have a much higher likelihood of benefiting from a Roth conversion.

For many people, the possibility of future tax rate hikes by Congress is a real concern.  Given the current level of government borrowing, the huge budget deficits, and the problems plaguing entitlement programs such as Social Security and Medicare, it is not difficult to imagine higher tax rates down the road.

In fact, income tax rates are scheduled to increase significantly in 2011. The current tax brackets of 25 percent, 28 percent, 33 percent and 35 percent will revert to their pre-2001 levels of 28 percent, 31 percent, 36 percent and 39.6 percent, respectively, next year.

This means that if you convert in 2010 and elect to defer the taxes on the conversion until 2011 and 2012, you could (depending on other items that affect your tax return) have to pay those taxes at a higher rate than if you paid them this year. In light of this, some people may be willing to pay taxes at current rates in order to hedge against potentially higher rates in the future. Personally, I think a Roth IRA can be a great tax-rate hedge. But as with all hedged bets, you might win and you might lose.

When thinking about taxes, we must also consider what higher income can do to the multitude of deductions, credits, and phase-outs that permeate the tax code.  For those collecting Social Security, this may be especially important, as the increase in income from the conversion may cause more of your Social Security benefits to be taxed in that year. On the other hand, if you don’t convert, your taxable income may eventually increase anyway due to the RMD requirements, potentially causing more of your Social Security benefits to be taxed later.

Another important tax-related consideration is this rule of thumb: Don’t convert unless you can pay the taxes from a source outside the IRA you are converting. This rule will let you keep the maximum amount of money growing tax-free. If you are under age 59 ½, the money you withdraw in order to pay taxes will be subject not only to income taxes but also to a 10-percent early distribution penalty.

To summarize, if you expect your income to increase in retirement, or if you expect (or want to hedge against) higher future tax rates and if you have enough assets outside your IRA to pay the additional taxes, then you may be a good candidate for a Roth conversion.


A  Roth IRA can be a very efficient tool for wealth transfer.  Because they are not subject to minimum distribution requirements, Roth IRAs can continue to grow undiminished by withdrawals during the owner’s life, thereby leaving a much larger asset to the IRA beneficiary.  Furthermore, this beneficiary will enjoy completely tax-free distributions from the Roth.

If you’re intending to leave a legacy to grandchildren, you may find this a particularly attractive vehicle because inherited IRAs can be distributed over the beneficiary’s life expectancy. With the presumably long life expectancy of a grandchild, required distributions should be relatively small, allowing this asset to keep growing tax-free for many years.


Accountants often find it a good idea for retirees to have a diversified pool of assets to draw from. This means withdrawals from some sources (401(k) plans and traditional IRAs, for example) are taxable while those from other sources (Roth IRAs) are tax-free.

If you convert only some of your IRA assets, you will have more flexibility to control your taxable income without having to reduce your cash flow.  For example, you could draw just enough from the taxable pool to stay within a certain tax bracket, meeting the remainder of your cash needs from your non-taxable assets.  If tax rates increase, you could use more Roth assets to avoid the higher rates.  If rates stay the same or decline, you could tap more of your taxable assets.

Estate taxes

If you are fortunate enough to have a sizable estate subject to estate tax (i.e. individual estate over $3.5 million or joint estates over $7 million in 2009), Roth conversions should be high on your list of financial tasks to consider this year. By prepaying the tax on an IRA through a Roth conversion, you can reduce your taxable estate by the amount of that tax.  This in turn would reduce your estate tax burden at death.

With estate tax rates as high as 45 percent, the potential estate tax savings here will almost surely outweigh all other considerations.  Depending on what happens with estate tax legislation this year, Roth conversion planning to reduce estate taxes could become a much more important issue.

Apply TIDE to your goals

Unfortunately, there is no magic formula to help you know for sure what is your best move. Every situation is different, and only you can determine which of these factors are most important to you.  A thorough analysis of these issues with a competent professional can definitely help you weigh the pros and cons, but at the end of the day, you have to live with the consequences.

Nevertheless, the removal of the Roth conversion limit is a wonderful opportunity for some people to put themselves in a better tax situation. Although the future is uncertain, it is not completely unmanageable.


Written by retired Merriman Advisor Phuc Dang

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By Merriman Wealth Management, Wealth Advisor

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