Roth IRA Conversion Will Never Look Better

With a market recovery and higher tax rates coming, this is probably the best year to make the switch.

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Despite being bombarded with ads and related information urging investors to consider Roth IRA conversions, baby boomers appear comfortable staying right where they are—on the fence. New rules that took effect this year remove income ceilings for IRA conversions and allow two years for people to pay any tax obligations incurred in the conversion.

USAA, the large insurance and financial services company, surveyed boomers in July 2009 and February of this year. Awareness of the new conversion rules increased nearly 20 percentage points to 58 percent. But 90 percent of boomers said this year that they would either not do a conversion or are unsure about it. Little changed—92 percent provided similar responses in last year's poll.

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Roth IRAs are funded with post-tax contributions but do not levy income taxes on later withdrawals and do not require minimum annual distributions. They may be conveyed in estates as is, allowing heirs to continue letting account gains build up with no income taxes due on withdrawals. If you like this benefit after only 10 or 20 years, imagine how much your kids might like it after another 30 or even 40 years. You could literally fund their retirements.

Regular IRAs are funded with pretax dollars, but withdrawals are taxed as ordinary income, and minimum annual withdrawals are legally required when the account holder turns 70½. Under earlier laws, households with taxable incomes exceeding $100,000 a year could not convert an existing IRA into a Roth. That $100,000 income limit on conversions has ended. Taxpayers making more than $120,000 a year ($176,000 for joint returns) still aren't eligible to make new contributions to a Roth.

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According to USAA, the top reasons people gave for not converting were that they expected lower tax rates when they retired (44 percent cited this); they were advised by a tax adviser or other financial professional not to convert (35 percent); and they could not afford the tax bill on the funds converted into a Roth (27 percent).

Ken Kilday, a USAA wealth adviser, says he doesn't know how many people should convert to a Roth, but he's confident that it's a lot more than the 10 percent who say they will. He was especially surprised at the large percentage of people who think their tax rate will decline when they retire. Tax cuts approved during the Bush administration are scheduled to expire next year, and it's hard to see them being reapproved by Congress. The three highest percentage tax brackets—28, 33, and 35 percent—are set to rise to 31, 36, and 39.6 percent. "We now have the third-lowest tax brackets since 1913," when the income tax first was approved, Kilday says. "It's tough to assume a lower tax rate in the future."

To ease the tax bite of a conversion, people can either take the entire hit on their 2010 returns, or they can defer it and split it equally between their 2011 and 2012 returns. If they elect a deferral, however, the income will be taxed at whatever rates are in effect in those years.

Many investment sites have Roth conversion calculators. The results are only as good as the assumptions you use. I ran some scenarios on this Morningstar calculator, using conservative assumptions. I used a $100,000 IRA balance for conversion and assumed that none of this balance had been funded with post-tax money. I also assumed annual returns of 5 percent now and in retirement (many calculators use higher returns as a default),and said that I would retire at the age of 70 and that my retirement would last 20 years. Tax rates are important, too. I used a current income tax rate of 28 percent and a 15 percent rate for long-term capital gains. Again, to be conservative, I said my tax rate at retirement would rise to 33 percent.

Using these assumptions, I entered various ages as of the end of 2010 and produced these comparisons:

At age 60 in 2010, converting to a Roth would cost $28,000 in 2010 taxes and provide post-tax income of $13,070 a year in retirement, compared with $11,681 for a traditional IRA.

At age 55 in 2010, converting to a Roth would cost $28,000 in 2010 taxes and provide post-tax income of $16,681 a year in retirement, compared with $14,729 for a traditional IRA.

At age 50 in 2010, converting to a Roth would cost $28,000 in 2010 taxes and provide post-tax income of $21,290 a year in retirement, compared with $18,590 for a traditional IRA.

At age 45 in 2010, converting to a Roth would cost $28,000 in 2010 taxes and provide post-tax income of $27,172 a year in retirement, compared with $23,483 for a traditional IRA.

At age 40 in 2010, converting to a Roth would cost $28,000 in 2010 taxes and provide post-tax income of $34,680 a year in retirement, compared with $29,685 for a traditional IRA.