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Three Questions to Ask Before an IRA Conversion

Christine Benz

Christine Benz: Hi, I'm Christine Benz for It's IRA Optimization Week on the site and here on the phone with me today is Ed Slott. He is the founder of and one of the country's foremost experts on IRAs. Ed, thanks so much for being here.

Ed Slott: Glad to be here.

Benz: So, Ed, you have written a lot about conversions, converting a traditional IRA to a Roth. Let's talk about who you see as the key candidates for conversion and also who should avoid it.

Slott: Well, the key candidates are just about everybody with an IRA who want to avoid taxes later on in retirement when they'll probably need the money most and tax rates might be much higher than they are today. But it basically comes down to three factors. I call the three questions; when, what, and where. When do you think you'll need the money, what do you think your future tax rate will be, and where you're going to get the money from to pay the tax.

That's the drawback, if there is one, you have to pay up front. And most people say, why on earth would I ever pay a tax before I have to. It's kind of like paying off the mortgage on your home. Most people don't think about it, but a retirement account has a mortgage on it, money that's owed back to the government. So, it depends when do you want to pay that back. If you pay it back now, all the future growth is tax-free forever. Now, with the new estate tax rules, it might even be estate tax-free forever.

So, you have to ask yourself the questions. When? If you're going to need the money soon, then it might not pay to pay a tax now if you're just going to take it out in five or 10 years.

What do you think your future tax bracket will be? Well, conventional wisdom says, that if you'll be in a lower bracket in retirement, maybe you shouldn't convert, but the downside is if you don't convert then you don't know what your tax bracket will be. A lot of people say, well I'll be retired, I will be in a low tax bracket. Well, you don't know what the tax rates are going to be.

I mean, the way this country is going with the deficits, I don't think these low rates that we have, which are historically low right now with the new tax law extended for 2011 and '12. I don't think that's sustainable, and they may jack rates up just when you come for yours in retirement. Now, you can lock in those low rates. So, I think you need to look at that, but if you truly think you'll be in the lower bracket, then it might not pay.

Then, of course, the third question, where are you going to get the money from to pay the tax? If you don't have the money to pay the tax, don't convert. Nobody should go broke converting and certainly don't use the money in the IRA to pay the conversion tax because that's a trap. If you do that and you're under 59 1/2, you'll have a 10% penalty on that money. So you should use other money, outside of your IRA to pay the tax. You might even want to pull that from some capital gains you might have. They're at historic low of 15% now, too. Remember, all of those low rates expire after 2012. So now, I think is the time to strike and seriously look at it.

The other big benefit for Roth conversions is it's a risk-free move to convert to a Roth IRA because it's one of the few provisions in the tax code that comes with do-overs. You can actually undo it. It's called a re-characterization. So, if you convert, say in 2011, you have until Oct. 15, 2012, over a year, to undo it for any reason. It's like getting to bet on a horse after the race is over. So, there's really no risk to it. So, I would say to do it, and if it doesn't work out, you can undo it.

Another benefit of Roths, as you get older, if you don't convert, you will be forced after age 70 1/2 to take required distributions. You won't have that in a Roth, so you can keep building and building tax-free. So, there are huge tax-free benefits to a Roth IRA. And even if you're worried about being in a low tax bracket in retirement, what's the big deal? The worst downside is that in retirement your tax rate will be zero. That's the worst-case scenario, and that's not too bad.

Benz: So Ed, when we initially started hearing a lot about conversions, I had been seeing conventional wisdom that older folks, people who are already retired should not be converting. What's your take on that issue, and how should seniors who may already be retired assess the appropriateness of conversion?

Slott: Start young. Younger people should definitely do it. I mean they have the greatest money-making asset that any individual can possess--time. Compound interest over time and add tax-free components, and some young people could have a multimillion dollar tax-free retirement in their 60s and 70s. So that's a no-brainer I think.

For older people, it's a little different. It depends. You have to ask yourself who you're doing this conversion for. What you said is true. If you're older, I'd say 75 or older and you're converting for yourself, I don't think it pays. The cost of paying the tax up front, given your own life expectancy is not worth it. But on the other hand, you could be a 100 years old, and if you're doing it for estate-planning purposes to pass a tax-free Roth on to children or grandchildren, then yes, it pays.

Again, if you don't need the money and you have the money to pay the tax, what a great legacy for children and grandchildren. So then you're not talking about just your short life expectancy that's left but you could be talking about a 50-, 60-,  or 70-year lifetime of tax-free growth for children and grandchildren. So if you're a senior and you're doing it for someone, another generation like children or grandchildren, then it pays; but for your own life, it probably doesn't.