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Converting to a Roth IRA? Answer These 3 Questions First

Ask yourself when you'll need the money, what your future tax bracket may be, and where you'll find the money to pay the taxes due upon conversion.

Retirement expert and author Ed Slott says that investors need to answer three important questions before converting from a traditional IRA to a Roth IRA. In a recent interview with Morningstar director of personal finance Christine Benz, Slott shared those questions, explained the importance of recharacterization, and revealed some common IRA conversion pitfalls.

Christine Benz: There are a lot of moving parts with IRA conversions. Deciding whether to take those traditional IRA assets that an investor has been building up and pay tax on them, and then convert them to Roth to enjoy the tax-free withdrawals in retirement can be a complicated decision. Where should investors go for advice? Should they seek out a tax advisor?

Ed Slott: You could seek out a tax advisor, or your own financial advisor. But I would first ask yourself three questions: when, what, and where.

The first question is, when do you think you'll need the money? If somebody tells me, "Well, I might need it in five years," I say don't convert. The benefit of paying a tax now is the long-term tax-free compounding opportunity that the Roth IRA offers. The longer you keep the money in that tax-free account, the more it will grow uneroded by taxes. But it doesn't pay for most people to pay a tax now just to take out the money in a few years. So, if people need the money in a few years, they're probably better off not converting from a traditional to a Roth IRA and giving up all that money to taxes upfront.

But if someone says, "I intend to keep the money in the Roth IRA for the rest of my life," it pays to convert. Remember, Roth IRAs have no required minimum distributions. Because of that, the compounding can really snowball and carry over to beneficiaries tax-free. The longer you plan on not touching the money, the more it pays to do a Roth conversion.

Benz: Is there a minimum amount of time that I'd want to have in terms of my time horizon?

Slott: If people are saying, "I need it in five or even 10 years," I would say that's too short a time frame to make the conversion worthwhile. You've got to go longer because it needs the time to snowball.

Benz: First, look at your time horizon. What's the next question?

Slott: What do you think your future tax bracket will be? That's really the biggest question, but the problem with that question is nobody knows the answer!

A lot of accountants and other advisors say, "I'm sure retired people all think they are going to be in a lower bracket in retirement." But if taxes go up, today's high tax bracket could be tomorrow's low bracket. You don't really know. Plus, at some point, if you don't convert, you are forced to take that traditional IRA money out at age 70 1/2 at the prevailing tax rate. If future rates go up to 40% or 50%, that would be a higher rate; but it's a double hit because if your IRA has done well, it's a higher tax rate on a higher balance. So, it might pay to bite the bullet now when your rate is knowable and your balance is lower.

If you think you'll be in a higher tax bracket later, it would pay to convert. It means you have to part with some money now--there's an opportunity cost. But look at the long-term big picture: The Roth IRA money is all building tax-free. And you won't have to worry about the uncertainty of what the possibility of future higher tax rates could do to your retirement savings just when you need the money most, in retirement.

Benz: And the final question, where?

Slott: Where are you going to get the money to pay the tax? If you don't have the money to pay the tax, you shouldn't be converting. You don't want to go broke converting. It's not for everybody. But if you have money sitting in taxable investments that are just going to be exposed to current and future higher taxes on your investment gains, that's the money to use.

You don't want to use the IRA money itself to pay the tax, because it's a diminishing return. You are converting less. Also, there is a trap. If you use the IRA money to convert, you're not converting everything. And one of the big benefits of a Roth conversion is the ability to get a second chance to undo it. It's called a Roth recharacterization. Once you convert, you can undo the conversion for any reason at all within a limited time period. Let's say you convert in 2015--you have until Oct. 15, 2016, to unwind that. But you can only undo or recharacterize the amounts that were converted. You'll lose the opportunity to recharacterize all of it if not all of it was converted. So, it's best not to use IRA money to pay the taxes related to converting.

Benz: So, don't raid some other 401(k) or IRA.

Slott: No. If you don't have the money, don't do it. I know it sounds outrageous on most accounts, but I tell people the best strategy is to convert everything, and they're shocked. They say, "I have $500,000 in my traditional IRA; I can't convert all of that."

Benz: It's a big tax bill.

Slott:  I still say to convert everything. Remember that you have until Oct. 15 of the next year to undo it all, to make the whole tax bill go away if you want. And by that time, you know exactly all the other items in your tax return. You can go back and un-convert or recharacterize right back to the number you actually want to keep. You can go at it from the back end. It's like getting to bet on a horse after the race is over.

Benz: As long as you mind those deadlines for recharacterization, it won't be taxable for you to undo the conversion entirely or partially.

Slott: Right. In other words, the key is not how much you convert, it's how much you recharacterize--or, in other words, how much of the conversion you actually keep.

Benz: Are there any situations where someone asks you about conversion, and you say without hesitation, "Yes, absolutely"? What are the situations where you give the green light?

Slott: Young people. The greatest money-making asset any individual can possess is time, and young people have more of it than anyone else. But they don't capitalize on it. Young people starting a job should be contributing if they can to a Roth, or should be converting if they've contributed to a traditional IRA. They probably don't have a big 401(k) so far, or they are in a low tax bracket. This is the opportunity of a lifetime to start building tax-free. I wish I'd had that opportunity. I had to pay a fortune to convert back in 2010 when they opened the floodgates and they repealed the income limits, but young people have an unbelievable opportunity now. So, if there is one absolute for a Roth conversion, it's that young people should all be converting and contributing to Roth IRAs. And at work, if they have the option, they should be contributing to Roth 401(k)s as opposed to 401(k)s.

Benz: Take advantage of that relatively low tax bracket, plus the long time horizon. How about the opposite? If your time horizon is too condensed, the conversion may not add up. Are there any other situations where conversion doesn't make sense?

Slott: It depends what you're converting for. I would say that if you are 70 or over and you're converting for yourself, to take out money during your lifetime, it probably doesn't pay because the cost you pay upfront, given your life expectancy, is probably not worth it. For example, my mother is 88, and she saw my show on public television. She called up and said, "Eddie, should I do that conversion?" I said, "Mom, no. It's not for you. Don't do it."

But if you are older and you're doing it for your beneficiaries, your beneficiary's time horizon could add another 50, 60, or 70 years of tax-free growth after your death. Then, it might pay.

Benz: What common pitfalls do you see related to conversions? Obviously, some pitfalls include what we've already discussed, including keeping an eye on what the tax bill associated with this conversion will be, minding time horizon, and minding whether you have external assets to use to pay the taxes. Are there others?

Slott: When you convert, you are opening a new account. Make sure you name your beneficiaries on this new Roth IRA. A lot of people miss that. Also, keep track of that recharacterization deadline. That's a hard deadline. It's Oct. 15 of the year after you convert. Don't let that slip by.

Some people don't keep track of aftertax money that's in their traditional IRA. You should be filing a form called an 8606 if you've contributed aftertax money to your traditional IRA. Let's say you have $100,000 in a traditional IRA that you want to convert, and $10,000 of it is after taxes; you should only be paying tax on $90,000. If you are not keeping track of your aftertax money in your IRA that came from nondeductible contributions or roll-ins from a plan of aftertax money, then you're paying tax twice on the same money. Be careful about that.