Can I convert my Traditional/Rollover IRA to a Roth IRA? Should I bother?

From FinancialPlanning

Rule for Converting

If you meet two simple criteria, you may convert your Traditional or Rollover IRA to a Roth IRA:

• your Modified Adjusted Gross Income must be under $100,000. Your "MAGI" is usually your adjusted gross income minus the amount of the conversion, though there may be some other adjustments.

• your tax filing status cannot be "married filing separately"

Note: The 2006 Pension Act removes the $100,000 income limitation in 2010. These FAQs will be updated as that date approaches.

How to Convert

Converting is a simple process -- just ask your IRA custodian for the paperwork to do it, and submit it in time to convert your account before the end of the year. Unlike contributions, the deadline for conversions is December 31 of a given tax year (or as a practical matter, the last business day before it).

Partial conversions allowed

It's not required that you convert 100% of your IRA value. You may convert any portion of it in a given year and leave the rest alone.

Effect of Conversion on Taxes

Each pre-tax IRA dollar that you convert to a Roth IRA is another dollar added to your taxable income -- another line item on page one of your IRS form 1040. If you convert a $30,000 IRA, it's as if you earned $30,000 in salary that year, and you'll pay additional income tax accordingly. Don't forget state taxes too.

MIFP Tip: convert during years in which you have low taxable income, or big tax deductions, to minimize the tax paid at conversion. Examples are years in which you return to school, take a sabbatical, or work at a start-up for low pay. Also, looking at your tax bracket might set limits on how much to convert in a given year. For example if converting more than $10,000 sends your taxable income into a higher tax bracket, you might convert only $10,000 this year and wait until next year to convert more.

If you had any basis in your IRA, from after-tax contributions, that portion of the conversion won't be taxed. You can't cherry-pick these dollars though, even if they all sit in a single account. If you do a partial conversion at a time that 10% of your total IRA value (all accounts) is from after-tax contributions, 10% of the converted amount won't be taxable, regardless of where you pull the dollars from.

Convert or Not?

The topic of whether to convert an IRA to a Roth has been debated extensively on MIFP. Numerous MIFP posters have done lengthy analyses comparing a Roth conversion to an IRA that is left alone, comparing the after-tax values of each. A key point in this comparison is that despite its tax-free nature the Roth doesn't always "win" and a dead heat is possible. While the Roth ends up being tax-free, you do pay taxes today on the conversion. Those are dollars that you won't leave invested.

But the big unknown is future tax rates. Even if you knew with a great deal of certainty how much money you'd have at retirement in your IRA (which is unlikely), only someone who is currently retired knows what tax rates they're paying. Tax rates and/or brackets change every year, as do the various exemptions and deductions. It's impossible to predict what taxes are going to look like 15, 20, or 30 years from now. This makes a quantitative comparison very difficult.

A few suggestions have emerged:

• make some assumptions and run the numbers regardless
• hedge your bets by leaving some dollars in Trad-IRAs, some in Roth IRAs
• assume future tax rates are going up, and get as much as possible into the Roth
• if your taxable income is likely to be high during retirement, and it's low now, assume that you're more likely to benefit from the Roth conversion
• if your taxable income is high now and will be low during retirement, assume that you're more likely to benefit by leaving the money in a regular IRA

All posters have agreed that if the conversion can be done at zero tax, there's no reason not to do it. There is some disagreement about how much tax at conversion is "too much", and likely to result in a lower net after-tax figure. Some take an aggressive stance and say that you should make use of any chance to convert because future tax rates are going to be much higher (usually citing economic factors like the national debt, trade deficit, Social Security funding, etc.). Others say to do it only if in the lower couple tax brackets.

The question of whether or not to convert will see much more discussion as 2010 approaches and the income limit is suspended. Whether someone invents a crystal ball by then that shows us the tax rates in 2040 remains to be seen.