2010 Roth Conversion: Look Before You Leap

by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
July 22, 2009

Beginning in 2010, the rules surrounding conversions of traditional IRA money to a Roth IRA will change so that everyone will be eligible. But, just because you can convert to a Roth IRA does that mean you should? As a general rule, tax planners advise against paying a tax today that you can defer until a later date. Of course, there are always exceptions to any general rule, and converting to a Roth IRA may well be one of them.

Before looking at the pros and cons of conversion in your unique situation, here’s a brief recap of the basics:

Roth IRA vs. traditional IRA

Traditional IRA—Money put into a traditional IRA is tax-deductible no matter how much money you make, unless you're covered by a qualified employer-sponsored retirement plan like a 401(k) in which case you may receive a reduced or no deduction for the contributions made to your IRA. If you are covered by an employer-sponsored plan, and you’re a single tax filer, a traditional IRA contribution is fully deductible for 2009 only if your modified adjusted gross income (MAGI) is $55,000 or below (deductibility phases out between MAGI of $55,000 and $65,000). If you're a married couple filing jointly, the ability to deduct your contribution phases out between $89,000 and $109,000 (or between $166,000 and $176,000 for the nonparticipant spouse of an active plan participant, when filing jointly).

Even though traditional IRA distributions are taxed at ordinary income tax rates, it can still make sense to contribute if you are eligible to receive an up-front deduction. However, because long-term capital gain and qualified dividend tax rates are currently lower than ordinary income tax rates, a nondeductible contribution to a traditional IRA rarely makes sense. In that case, there's no up-front deduction, and earnings are eventually taxed at higher ordinary income rates when withdrawn. If you’re not eligible to deduct your traditional IRA contribution and you’re not eligible to contribute to a Roth IRA, then it’s usually better to invest tax-efficiently in a regular brokerage account so you can take advantage of lower long-term capital gain rates.
Roth IRA—With a Roth, contributions are not tax-deductible, but earnings can be withdrawn income-tax-free if you're at least 59½ and have had the Roth at least five years. And you don't need to take required minimum distributions starting at age 70½, as you do with a traditional IRA. For 2009, the ability for single filers to contribute to a Roth phases out if your MAGI lies between $105,000 and $120,000; for married filing jointly, eligibility phases out between $166,000 and $176,000. The maximum contribution for 2009 for either to a traditional IRA or Roth IRA is $5,000. If you’re 50 or older, you can contribute an additional $1,000. You can choose either type of account or contribute to both, but your total contribution cannot exceed the maximum of $5,000 (or $6,000 if you’re 50 or older).

So, if you qualify for a deductible traditional IRA and a Roth IRA, which one makes the most sense? While facts and circumstances may vary, here are some generally applicable rules of thumb to help you choose wisely:

If you have many years to go before you'll need to withdraw the money in retirement and you think your income tax bracket will be the same or higher when you retire than it is today, then a Roth IRA probably makes sense. For example, a Roth can be especially attractive for younger workers who are far from their peak earning years.
If you think your income tax bracket will be lower when you retire, you may be better off taking the up-front deduction of a traditional IRA.

Roth IRA conversion
If you’re not eligible to contribute to a Roth IRA and your employer’s plan doesn’t allow you to make Roth-designated contributions to your 401(k) plan (a fairly recent development that not every employer plan allows), then another way to take advantage of a Roth IRA's potential benefits is to convert some or all or your traditional IRA money to a Roth.

Through 2009, you can’t convert from a traditional IRA to a Roth IRA if your modified adjusted gross income (MAGI) on your federal income tax return is over $100,000. Beginning in 2010 (and beyond) that limitation is abolished. In addition, there's a special rule in place for 2010 only that will allow you to recognize 100% of the conversion income in 2010 or split it equally between the next two tax years (2011 and 2012).

Even though you have to pay current income tax on the amount you convert to a Roth IRA, it still might make sense if:

You think you will be in the same or a higher tax bracket when you withdraw,
have a long time horizon, and
can pay the tax from sources other than your IRA, such as from regular taxable brokerage or bank accounts. (See the additional notes about paying the conversion tax below.)

or
You don’t need to use the money and want to leave an income-tax-free Roth IRA to your heirs for gift and estate-planning purposes.

A few important notes about paying the conversion tax:

If you pay the tax from your IRA, you would lose the potential benefit of tax-free growth on that amount, defeating the purpose. Of course, if you’re under 59½, withdrawing money to pay the tax would be an even worse idea, since you would also incur a 10% federal penalty. (State penalties may also apply.)
Ideally, you will have cash on hand to pay the income tax. If you need to sell appreciated assets to pay the conversion tax, the additional capital gains tax would work against the case for a Roth conversion.
Assuming you have the cash available elsewhere to pay the conversion tax, you still need to account for the “opportunity cost” of what that money could have earned had it remained invested in a taxable account. (See hypothetical example below.)

Hypothetical example
In this example, we estimate the dollar advantage or disadvantage of converting $1,000 from a traditional IRA to a Roth IRA. We assume a current income tax rate of 25% and a 6% average annual return. As you can see from the table below, a future retirement tax rate equal to or higher than the current tax rate favors the Roth conversion, while a lower future tax rate favors leaving the money in a traditional IRA. Of course, given these assumptions, the longer the time horizon the greater the advantage (or disadvantage).

Advantage (Disadvantage) per $1,000 of Conversion, Current Tax Rate 25%, 6% Average Annual Rate of Return¹
Future Tax Rate	Time Horizon (years)
Future Tax Rate	5	10	15	20
35%	$149	$216	$308	$435
25%	$15	$37	$69	$115
15%	($118)	($142)	($171)	($206)

Note that a Roth conversion has a slight advantage even if the future tax bracket remains the same. That’s because we assume that current taxes will be paid from taxable accounts and the full conversion amount will go into the Roth. If taxes were paid from the IRA at the time of conversion, then there would be no advantage or disadvantage no matter how long the time horizon, assuming the future tax rate is the same. For example, consider the following scenario:

Traditional IRA balance = $1,000

Current federal income tax rate = 25%

Future federal income tax rate = 25%

If you pay the conversion tax using IRA funds, you are left investing $750 in your Roth. Assuming an average annual return of 6%, after 20 years you will have $2,405 in your Roth.

If you left your traditional IRA alone and earned the same return, you would have $3,207 after 20 years. Assuming the same tax rate of 25%, you would end up with exactly the same amount after withdrawing the money and paying $802 in federal income taxes: $2,405.

Of course, it would be even worse if you were under 59½ at the time of conversion and used IRA funds to pay the tax, since you would also incur a 10% federal penalty (a state penalty, and taxes, may also apply).

Keep in mind that the bigger your Roth balance, the greater the potential advantage. That's why it's important to pay the conversion tax from outside funds, if possible. Of course, you still need to account for the "opportunity cost" of taxes paid with outside funds, since that money could have been invested all along if you just did nothing and left your traditional IRA alone. However, as you factor in the hypothetical opportunity cost in your analysis remember that the ongoing return lost to taxes each year and long-term capital gains tax at liquidation of this hypothetical opportunity cost account are likely less than the ordinary tax rate you would incur on a future withdrawal from a traditional IRA (which is why there would be a slight advantage with the Roth conversion even if the future tax bracket remained the same).

Who most stands to gain by the 2010 change?
Remember, the primary reason for the rule change was to accelerate the collection of income taxes that might have otherwise been locked up in traditional IRAs for decades to come. That doesn't mean it still can't be a good deal for certain taxpayers under the right set of facts and circumstances. But, who is most likely to gain from Congress' “generosity” (besides the U.S. Treasury)?

For those with incomes between $100,000 and $250,000, the newfound eligibility for a Roth conversion might be worth a closer look. (Those at $100,000 or below were already eligible, so the 2010 change is moot.) Taxpayers in the top brackets might find the projections less compelling because of a lower probability they will be in the same or a higher bracket after retirement. Nevertheless, if you’re in the highest brackets and expect to stay that way throughout retirement, it could still make sense—especially if you’re convinced that tax rates will continue to rise no matter how much you make.

Income taxes aside, very high net worth individuals may find that converting part or all of a traditional IRA to a Roth is advantageous for estate-planning purposes, especially if there is a significant IRA balance that doesn’t need to be tapped during the owner’s lifetime. Though the value of a Roth will still be included in the gross estate, because there are no required minimum distributions, the account could grow larger than it otherwise might under traditional IRA distribution rules—leaving more for heirs to withdraw income-tax-free over their lifetimes. What's more, the income tax paid at the time of conversion (preferably from assets other than the IRA) will reduce the owner’s gross estate. In effect, the account owner is prepaying income tax on behalf of future beneficiaries without it really counting as a taxable gift.

Other considerations
Here are a few more caveats to consider:

Traditional IRA aggregation rule: If you have made nondeductible contributions to your traditional IRA in the past (hopefully, tracked all along on IRS Form 8606), you can't pick and choose which portion of the traditional IRA money you want to convert to a Roth. The IRS looks at all traditional IRAs as one when it comes to distributions, including Roth conversions. Traditional IRA balances are aggregated so that the amount converted consists of a prorated portion of taxable and nontaxable money. For more on the aggregation rule, see IRS Publication 590.
Converting nondeductible IRA contributions to a Roth: Starting in 2010 high earners otherwise not eligible to make Roth contributions could make nondeductible contributions to a traditional IRA and then convert those amounts to a Roth. This process could be repeated every year. Don't be surprised, though, if Congress changes the law to eliminate this option.
Multi-year tax payment: Being able to split the conversion income between 2011 and 2012 for 2010 conversions (only) is a potential benefit only if your tax rate doesn't rise. But higher rates in 2011 and 2012 vs. 2010 are almost a certainty for top earners.

The bottom line
Eligibility for a Roth conversion in 2010 doesn’t automatically make it a good idea. In fact, the very high-earning taxpayers who will become eligible for Roth conversion in 2010 are the least likely to benefit because they are already in the highest brackets. If a Roth conversion didn’t make sense for income tax purposes before 2010, it probably won’t afterwards. That said, in the right circumstances, converting to a Roth IRA can potentially have significant benefits. Conversion for estate-planning purposes may also add value. Each situation needs to be evaluated on a case-by-case basis. Take a close look at your own situation and, if it makes sense, consider taking advantage of these rule changes. Remember that tax laws are subject to change, so stay current at www.irs.gov. Also, be sure to talk with your accountant or other professional tax advisor about whether converting to a Roth makes sense for you.

Finally, if you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.

1. Table shows the difference between the projected future values of the Roth minus traditional IRA. Note that we subtract an opportunity cost from the Roth projection, assuming the conversion tax paid from taxable accounts would have been invested the same but would lose some return to ongoing taxation, as well as a 15% long-term capital gain tax on the adjusted cost basis at liquidation.

Important Disclosures
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized advice.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, Financial Planner or Investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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