Making the Decision

Am I eligible to convert my existing IRA into a Roth IRA?

Yes. Almost everyone with an IRA (including Traditional, Rollover, SEP and SIMPLE IRAs) is eligible to convert to a Roth IRA. Even a former employer’s retirement plan (e.g. 401(k), profit sharing, and 403(b)) may be eligible to convert to a Roth IRA.

What was the "special tax treatment" that 2010 Roth conversions received?

For 2010 Roth conversions only - the taxable conversion amount was automatically divided equally between 2011 and 2012, with one-half of the taxable conversion taxed as ordinary income for 2011 and the other half of the taxable conversion taxed as ordinary income for 2012¹.

For conversions in 2011 and beyond, the taxable conversion amount is typically taxed as ordinary income for the year of conversion.

If I choose to convert, do I have to convert my entire IRA account?

No. You can convert all or any part of your account - the choice is yours.

If I convert to a Roth, can I still contribute to a Traditional IRA in the future?

Yes. Converting does not affect your ability to make future contributions to either type of IRA.

How will withdrawals from my Roth IRA be taxed?

You can withdraw money entirely tax-free after five years if you are over age 59½, disabled, or making a first-time home purchase (up to $10,000). If you take money out before then, earnings will be taxable and, before age 59½, may be subject to an additional 10% penalty tax.²

What if I convert to a Roth, then discover that my income was too high to qualify for conversion?

You may reverse a conversion without any tax consequences - regardless of the reason - by transferring the money (including earnings) back into a Traditional IRA by the due date of your tax return, including extensions.

What are the main points I should consider in deciding whether to convert?

The bottom line is this: Will you come out ahead by paying taxes now on your existing IRA funds in exchange for receiving all future earnings tax-free? The answer depends on several factors...

• How will you pay the conversion tax?
  In most cases, conversion will not make sense if you must take the tax money out of your IRA. The amount you pull out will lose the benefit of tax-free compounding and could be subject to a penalty tax. Example A shows a scenario in which conversion taxes are paid from non-IRA assets.
• What will your future tax bracket be?
  The advantage of tax-free withdrawals from a Roth IRA is reduced if you expect to be in a much lower tax bracket when you begin withdrawals (see Example B). How do you predict your future tax bracket? Your financial adviser can help you make an educated guess.
• How long will your funds stay in the IRA?
  Example B also shows that the longer you let your IRA money accumulate before taking withdrawals, the greater the advantage of the Roth IRA.
• What's the taxable amount in your existing IRA?
  If you've primarily made nondeductible contributions in the past, it may not cost you much to convert. And the lower the tax bite, the wiser conversion may be.
• Do you plan to leave your IRA money to heirs?
  Unlike other IRAs, Roth IRAs do not require that you start taking money out when you reach age 70½. So you can let your funds compound tax-free for as long as you live, and leave money to the next generation in a very tax-efficient way.
• Are you (or will you soon be) collecting Social Security?
  If so, you'll need to consider how a Roth conversion will affect the taxes due on your Social Security benefits. Although Social Security payments are not taxable if your overall income falls below certain limits, the taxable income from a Roth conversion could put you over the top. On the other hand, any future Roth withdrawals that are tax-free are not included in income, so they will never affect the taxes due on your Social Security benefits.

Example A

• Let's say you have an IRA worth $20,000 earning 8% annually. You're currently in a 28% tax bracket, and expect to drop to a 25% bracket when you retire 20 years from now. If you do not convert to a Roth IRA, your account will net you $69,914 in 20 years, after paying 25% in taxes.
• Now suppose you convert to a Roth IRA. You'll owe $5,600 ($20,000 x 28%) in conversion taxes. If you pay the conversion tax out of pocket - without tapping your IRA - you'll end up with $93,219, or $23,305 more than if you hadn't converted.
• To make a fair comparison, let's consider how much $5,600 would have grown if you hadn't used it to pay conversion taxes. The answer: $17,093, assuming you invest the money in a taxable account earning 8% until retirement. As you can see, you still come out ahead with the Roth, even after paying taxes up front.

• To summarize, here is what your $20,000 would be worth in 20 years if:

• You do not convert to a Roth IRA: $69,914
• You convert and pay tax from non-IRA assets: $93,219
• You do not convert and invest the amount you would’ve paid in conversion tax ($17,093): $84,211

Example B

• Suppose you have a $20,000 IRA earning 8% annually, and are now in a 28% tax bracket. The table below shows how you would fare in various scenarios. The projected balances, shown after taxes, assume that you will pay conversion taxes from non-IRA assets. The example also assumes that any tax money saved by not converting grows in a taxable account at 8% and is then added to the final (non-conversion) IRA balance.