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The Roth IRA Conversion Clock is Ticking

With only a few months left in 2010, time is running out to take advantage of a valuable and often misunderstood opportunity.

Beginning this year, all taxpayers are allowed to convert their traditional IRAs to Roth IRAs, regardless of their income levels. With tax rates scheduled to increase next year and the stock market down year-to-date, anyone who hasn’t considered converting all or some of their IRA should be taking a long, hard look at this opportunity before the end of the year.

Why the rush? First of all, with the stock market down and asset prices continuing to fall, now is a good time to lock in today’s prices and shift future appreciation into a tax-free account. Second, you are only allowed to revoke a conversion (more on this below) once a year. After a conversion is revoked, you have to wait until the following year or 30 days (whichever is later) before you can convert again. So by waiting until 2011 to start the conversion process, you’ll miss a valuable window of time that you won’t be able to get back.

While there are several variables to consider when deciding whether to convert your IRA, the two main factors are whether you have funds outside of your retirement accounts that you can use to pay the taxes associated with a conversion, and your expectations for your current and future tax rates. If you have non-IRA assets that can be used to pay the income tax associated with a conversion, converting is likely to be attractive. And if you expect your tax rate to be the same or higher in the future than it is currently, you’re also likely to find conversion appealing.

Many people have done the analysis and decided to convert. Fidelity Investments says that as of June 30, it had handled 100,000 conversions — four times the number for the same period last year. I have found that while the mainstream media has done a good job of raising awareness for this opportunity with the general public, there are two main misconceptions out there that are preventing taxpayers from converting their IRAs.

The first misconception is that the upfront tax associated with a conversion penalizes the taxpayer. While no one likes to pay more taxes, the important thing to understand here is that there is a tax liability embedded in your IRA. You can pay it now or you can pay it later, but eventually Uncle Sam will get his cut. And since you presumably expect your IRA to grow over time, this means the embedded tax liability will grow alongside it. Suppose you have a $100,000 IRA, your tax rate is 35%, and you expect the value of your IRA to double in 10 years. The question isn’t whether you’d rather pay $35,000 now or in 10 years (in which case you’d choose to defer the tax); the question is whether you’d rather pay $35,000 now or $70,000 in 10 years. We’ve found for our clients that it is often better to pay the tax up front, in exchange for the ability to avoid paying taxes on the future appreciation.

The second misconception is that converting can backfire and lead to regret. I view the conversion decision as a “heads you win, tails you break even” decision. This is because IRA conversions are revocable. The reversal of an IRA conversion is called an IRA recharacterization, and you can use it to make sure that your worst case scenario is break-even. (By recharacterizing, it’s as if you never converted your IRA.) There are two instances where recharacterizing would be in your best interest: if the value of your converted assets declines, or if a conversion pushes you into a higher tax bracket. You have until October of the year following the conversion to decide whether, or how much, to recharacterize. So while the recharacterization decision can be complicated, you’ll have plenty of time to review it from all angles.

In addition to these misconceptions, we have found that online calculators will often give the wrong answer to people wondering whether a conversion is right for them. For example, for someone with a large IRA that is not in the top tax bracket, many online calculators will tell them that they should not convert. This is because a one-time conversion will push this person into a higher tax rate, and lead to the assets being taxed at higher rates than they otherwise would have been. But this analysis is incomplete. While a full conversion isn’t in this person’s best interest, a partial conversion will still save them money. Using a conversion and a subsequent partial recharacterization, you can recognize just enough income each year to stay out of a higher tax bracket, and still take advantage of this opportunity.

IRA conversions are not for everybody, but our analysis has shown that they are right for a lot of people. While it can take years to complete the conversion process, we have been initiating the process for clients and for ourselves. Tax laws can and do change, so don’t miss your chance to take advantage of this opportunity while you still can.

Vice President and Chief Investment Officer Paul Jacobs, of our Atlanta office, is the author of Chapter 20, “Giving Back,” in our firm’s most recent book, The High Achiever’s Guide To Wealth. He also contributed several chapters to the firm’s previous book, Looking Ahead: Life, Family, Wealth and Business After 55.

The views expressed in this post are solely those of the author. We welcome additional perspectives in our comments section as long as they are on topic, civil in tone and signed with the writer's full name. All comments will be reviewed by our moderator prior to publication.

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3 Responses to "The Roth IRA Conversion Clock is Ticking"

  • Jerome Porter
    September 7, 2010 - 11:28 pm

    Good commentary as far as it goes.

    While the author points out that the common online calculators often do not calculate a suitable answer for the (discounted present) dollar value of the advantages of a conversion there is no indication of where one might find the favorable value that he implies is often really there.

    Most of the folks (in the business world) that I have dealt with (over the last few decades) are unwilling to bet serious money on a computation that they can not see and probe before they write the check. This is a long term transaction (from now to some period that lasts between retirement and death) and the ability to unwind it in the next 12 to 13 months does not help if no one can show them an unmysterious version of the analysis before the deadline for unwinding.

    Where does one find the work-sheets of equivalent for the implied alternative analysis that demonstrates the financial results that justify the up-front tax cost?

    The argument would be a lot more compelling if it included (or linked to) several specimens of the answers in the on-line calculators and the contrasting answers in “our analysis” that demonstrate how “our analysis has shown that they are right for a lot of people”.

  • Henry Rubin
    September 27, 2010 - 10:01 pm

    Is another advantage to converting this year the 2 year spreadout of taxes? I assume the spreadout is only for 2011 and 2012. Am I missing anything?

  • Paul Jacobs
    September 28, 2010 - 4:59 pm

    You are correct that the option to pay the tax over two years is only available for those that convert this year.

    Paying the taxes associated with a conversion with your 2011 and 2012 tax returns can be beneficial, but in some situations you’re better off paying the tax now. For example, if you expect to be in a higher tax bracket in either year, you may be better off paying the lower tax now. With so much uncertainty surrounding future tax rates, the decision of whether to pay the tax in 2010 or 2011/2012 doesn’t need to be made until April 2011.