Retirees' Frequently Asked Questions About Roth Conversions

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Retirees' Frequently Asked Questions About Roth Conversions
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
October 23, 2009

Key points

There are many important factors to consider when deciding whether it would be worthwhile to convert your traditional retirement account to a Roth IRA.
In 2010, the IRS is eliminating income restrictions so that anyone can convert to a Roth IRA.
Helpful for retirees who may have questions about Roth IRA conversions.

Many people, including retirees, are wondering about Roth IRA conversions because of the upcoming rule changes. As of January 1, 2010, the IRS is eliminating income restrictions so that anyone can move (or "convert") money from a traditional IRA or 401(k) to a Roth IRA.

The new rule change has left a lot of retirees asking if a Roth conversion might make sense for them, particularly when it comes to the income-tax and estate-tax implications associated with converting. Here we answer common questions from retirees about Roth conversions.

If a Roth IRA conversion forces me to pay income tax on my retirement money before I would otherwise have to, why would I want to convert?
I'm already retired and don't expect my income-tax bracket to change that much either way going forward. Would a conversion still make sense?
What are the estate-tax benefits of converting to a Roth?

If a Roth IRA conversion forces me to pay income tax on my retirement money before I would otherwise have to, why would I want to convert?
For some people, a Roth conversion may mean a larger portfolio or more generous estate-planning opportunities. For others, the cost of converting and other considerations could outweigh the potential benefits. Several factors will determine whether it would be worthwhile for you to convert:

A potentially larger portfolio. Even though you have to pay income taxes on the amount you convert to a Roth IRA, a conversion could leave you with a larger portfolio (after paying taxes) if:
1. You think you will be paying income taxes at your current rate or higher when you begin making withdrawals from your IRA,
2. You can pay the income taxes due on the conversion from a source other than your traditional IRA or other retirement account—such as from a taxable brokerage or bank account, and
3. There is a long-enough time before you begin making withdrawals.
Here are the details:

1. Your future tax rate. This is the most important factor in your decision. If you think you'll be in the same or a higher income-tax bracket when you make withdrawals, a Roth conversion could possibly help you end up with a larger after-tax portfolio than if you kept your money in a traditional IRA. That's because the taxes you'd pay now if you converted would probably be less than the taxes you'd pay when you withdrew money from your traditional IRA.

2. Your ability to pay the conversion tax. You will have to pay ordinary income taxes on the amount you convert (specifically, on pre-tax contributions and investment gains). You should not convert if you can't pay the conversion tax from sources other than your retirement accounts. Paying your conversion taxes from a non-retirement account, such as a taxable bank or brokerage account, is important because if you pay the taxes from your traditional IRA, you will lose the potential benefits of tax-free growth on that amount. In addition, if you're under age 59½, you could end up paying a 10% federal early withdrawal penalty if you take money out of your traditional IRA to pay the tax on the conversion. And you may also owe state tax penalties.

3. Time before withdrawals begin: The IRS requires that you keep the money you convert in your Roth IRA account for at least five years. If you are under age 59½ and withdraw the converted funds before the five-year waiting period, you could end up paying a 10% early withdrawal penalty. The good news is that the longer you leave your money in the account, the more time there is for potential tax-free growth, and a better chance of recouping the taxes you paid on the amount converted.
Estate-planning opportunities. A conversion may also be a good idea if you have other sources of retirement income, don't need to use your traditional IRA money during your lifetime, and want to leave an income-tax-free Roth IRA to your heirs for gift and estate-planning purposes. (See What are the estate-tax benefits of converting to a Roth?)

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I'm already retired and don't expect my income-tax bracket to change that much either way going forward. Would a conversion still make sense?
If you're currently tapping your traditional IRA for living expenses you probably wouldn't want to convert the entire balance. But, under certain circumstances, a partial conversion might make sense for you.

For example, if you are a younger retiree with sizable traditional IRA balances, you might yet face a higher income-tax bracket at age 70½, when the IRS requires that you begin taking minimum distributions (RMDs). If that will be the case, converting some of your traditional IRA money to a Roth IRA before age 70½ could reduce the RMDs from your traditional IRA, thereby lowering your overall future taxable income and potential tax rate. (Roth IRA withdrawals are income-tax-free and can be taken at your discretion.)

Additionally, having money in an income tax-free Roth IRA can give you increased flexibility in managing your future tax bracket, especially since there are no RMDs from a Roth IRA. Having investment assets spread among three basic types of accounts allows you to choose where your cash flow will come from, enabling you to better control your tax bracket.

For instance, you could keep stocks that you plan to hold for more than a year and tax-exempt municipal bonds in your taxable brokerage account in order to take advantage of lower tax rates for long-term capital gains and qualified dividends. You could also keep some investments in your tax-deferred traditional IRA, which will require you to pay ordinary income taxes only when you make withdrawals.

And you could hold other investments in your tax-free Roth IRA account, which allows you to make qualified withdrawals income-tax-free. Keep in mind that, unlike traditional IRA distributions, which increase taxable income, Roth IRA withdrawals do not affect the taxability of Social Security, potentially allowing you to keep more of your future Social Security benefits.

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What are the estate-tax benefits of converting to a Roth?
Aside from potential income-tax benefits, converting part or all of a traditional IRA to a Roth could be advantageous as an estate-planning strategy if you have significant IRA balances that you don't plan to tap during your lifetime. The value of your Roth account will still be included in your gross estate for estate-tax calculations. But, because RMDs aren't required in a Roth account, your portfolio could have the potential to grow larger in a Roth than in a traditional IRA—leaving more for your heirs.

Also, because you pay the income tax on the Roth conversion up front, your heirs will inherit your Roth IRA free of income taxes. By contrast, your heirs would have to pay income taxes on money they withdraw from an inherited traditional IRA.

What's more, the income tax you pay on the conversion will reduce your gross estate. In effect, when you convert to a Roth for estate-planning purposes, you're making a gift by prepaying the income tax on behalf of your beneficiaries without it really counting as a taxable gift. This strategy could be particularly advantageous to your heirs in situations where there's no taxable estate to speak of, because in such instances there would be no future income-tax deduction available to beneficiaries for previously paid estate taxes.

Even when a future deduction for estate taxes attributable to an inherited traditional IRA would be available, it might still be advantageous to convert to a Roth, primarily because the converted Roth would not be subject to RMDs during the original account holder's lifetime—and therefore the balance could potentially grow much larger. Obviously, this strategy requires some serious number crunching.

Making informed decisions
A Roth conversion is a complicated, individual decision with financial and tax consequences. We recommend that you work with your investment professional and tax advisor to determine whether a conversion is right for you.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative (or "informational") purposes only and not intended to be reflective of results you can expect to achieve.

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Take action

Call 800-424-5750 for your Roth IRA conversion review and report
Visit schwab.com/roth for additional resources
Use the Roth IRA Conversion Calculator