Beginning this year all workers have the option to convert a traditional IRA to a Roth IRA. In previous years conversions were restricted to employees who earned less than $100,000 annually. The removal of the income restriction has increased interest in this financial maneuver. Seven times more Vanguard IRA participants converted to a Roth IRA in January 2010 than in 2009.
But only certain groups of retirement savers will come out ahead by moving their money. Investors who shift their tax-deferred retirement assets to a Roth IRA must count that amount as taxable income. Those who make transfers in 2010 have the option to pay the tax this year or pay tax on 50 percent of the income in 2011 and the second half in 2012. In future years the tax must be paid entirely in the year of the transfer.
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A new Center for Retirement Research at Boston College analysis identified three types of investors who would benefit by converting their traditional IRAs to Roth IRAs. Here is who could come out ahead by making the switch.
Investors who will have a higher tax rate in retirement. Retirees who expect their tax rate to fall after they exit the workforce would accumulate the biggest nest egg by leaving their retirement s in the traditional IRA. Those who expect to pay higher taxes in retirement could do better by converting their nest egg to a Roth. Consider a retirement saver with a $5,000 traditional IRA balance who is currently in the 28 percent tax bracket and expects to earn a 7 percent rate of return. If the worker’s tax rate falls to 15 percent in retirement the $5,000 would be worth $8,360 in 10 years. But if his tax rate rises to 35 percent the account would only be worth $6,393 after taxes, according to Boston College calculations. If the worker coverts to a Roth IRA and pays the taxes up front from his retirement account, his balance would be worth $7,082 regardless of whether the tax rate rises or falls. If this worker stays in the 28 percent tax bracket he will have the same amount - $7,082 - whether he converts or not.
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Savers seeking more control over retirement account withdrawals. Traditional IRA account holders must take required minimum distributions –and pay the resulting income tax – each year after age 70 ½. The withdrawal amount is calculated by dividing your retirement account balances by your life expectancy, as determined by the Internal Revenue Service. Roth IRAs have no minimum withdrawal requirements.
[See 7 Penalty-Free Ways to Tap Your IRA Before Retirement.]
Those interested in maximizing tax-sheltered assets. A Roth IRA conversion produces the greatest results for investors who don’t use their IRA account to pay the taxes. Retirement savers who shift traditional IRA assets to a Roth IRA and pay the income tax for the conversion from sources outside their retirement accounts can boost their total amount of tax-sheltered assets. “Conversions of traditional IRAs to Roth accounts also can be attractive for people who wish to relax the limits on their annual contributions to tax-exempt IRA accounts,” write Richard Kopcke and Francis Vitagliano of Boston College. For example, an investor in the 28 percent tax bracket who converted a traditional IRA worth $5,000 to a Roth IRA and paid the $1,400 income tax from a taxable investment account would yield $9,836 in 10 years, according to Boston College calculations. If he had not made the conversion and remains in the same tax bracket in retirement he would have just $9,371 in the IRA and investment account combined. Using money outside your IRA to pay the income tax also allows investors under age 59 1/2 at the time of the conversion to avoid a 10 percent early withdrawal penalty that applies unless the complete IRA withdrawal is transferred to the Roth IRA.
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