Maximizing the New Roth IRA Opportunity


The markets created an opportunity for investors to convert traditional IRAs to Roth IRAs. The opportunity will last only as long as the financial crisis lasts and markets are bearish. Investors who converted their IRAs into Roths earlier this year probably should reverse them and consider converting again next year.

The benefits of a Roth IRA are well known. There are no front-end benefits such as a deduction for contributions. Only after-tax money can be contributed to a Roth IRA. But earnings compound tax-free within the Roth IRA. In addition, qualified distributions from the Roth are tax free. A qualified distribution is one that is taken the later of five years after the Roth is opened and after age 59½. In addition, the original owner of a Roth IRA is not required to take required minimum distributions after age 70½, though beneficiaries who inherit Roth IRAs are required to take RMDs after inheriting them.

A traditional IRA can be converted into a Roth IRA. In 2008 and 2009, the IRA owner must have adjusted gross income under $100,000. (Those with higher AGIs will be able to convert in 2010 and later years.) In addition, the owner must pay a conversion tax on the converted amount. The amount converted is included in gross income as though it were distributed. There is no 10% early distribution penalty on the converted amount if the owner is under age 59½.

This is a good time to consider converting, because the bear markets in 2008 drove down the value of most IRAs. A traditional IRA can be converted into a Roth IRA at a much lower cost than a few months ago and probably at a lower cost than sometime in 2009 after the markets recover.

Converting a traditional IRA to a Roth IRA is not for everyone. When does it make sense to convert a traditional IRA to a Roth IRA? There are several factors to consider.

§ How will taxes on the conversion be paid? The conversion is more valuable and passes the break-even point faster if the taxes are paid from non-IRA accounts so that the entire IRA is converted and begins compounding. If part of the IRA must be distributed and used to pay taxes, it takes longer for the conversion to pay off. In addition, if the owner is under age 59½ and uses a distribution from the IRA to pay the conversion taxes.

Because assets outside the IRA should be used to pay the taxes, it might make sense to convert an IRA over a period of years. Determine how much cash is available outside the IRA to pay income taxes this year, and convert the appropriate amount of the IRA for that level of taxes. More of the IRA can be converted in later years as cash is available to pay the taxes.

§ How long will the Roth IRA be left to compound before distributions begin? The goal in making the conversion is to have more after-tax wealth in the long-term. To accomplish that the converted amount must be allowed to compound its income and gains to make up for the taxes that were paid. If conversion taxes are paid from a taxable account and the IRA earns at least 8% annually, it takes at least seven years of compounding to reach the break even point. A longer compounding period generates more after-tax wealth for the owner than keeping the traditional IRA would have. A lower rate of return means a longer compounding period is needed to break even.

§ Will the tax rate be different when distributions begin? If the tax rate will be lower than in retirement than it is today, it might not make sense to pay taxes at today's rate unless there is a substantial compounding period. But if you anticipate higher tax rates in retirement, converting at today’s tax rate is profitable.

§ Will future Social Security benefits be taxable? If the taxpayer estimates having a high enough retirement income for benefits to be taxed, a conversion could reduce those future taxes. The Roth distributions are not included in gross income under current law while traditional IRA distributions are. If IRA distributions will be a big part of retirement income, shifting them to a Roth could save the Social Security benefits from taxes.

§ Will required minimum distributions from the traditional IRA exceed spending needs? When an owner has a large IRA and enough assets outside the IRA to meet living expenses, it might make sense to empty the IRA early. This is discussed in more detail in my book, The New Rules of Retirement. The RMDs force unneeded distributions and increase income taxes for both you and eventually your heirs.

An alternative to emptying the IRA early is to convert the IRA to a Roth IRA. This is not possible for many owners of large IRAs because of the $100,000 income limit, but it will be possible in 2010 when the income limit is removed.

§ What will state income taxes be? Not all states exempt Roth IRA distributions from income taxes. This should be checked before a conversion is undertaken.

Many mutual funds and other financial services firms have calculators on their web sites to help determine if converting to a Roth IRA will increase after-tax wealth. A good calculator also can be found at A few other calculators with no ties to financial products or services are at,,, and Financial planners of course can provide calculations.

IRA owners should consider each year whether a conversion would be profitable. After a conversion is done, the IRA and tax situation should be monitored. The owner might want to reverse the conversion. Those who converted traditional IRAs to Roth IRAs earlier this year should consider reversing the conversion, known as a recharacterization. You would want to recharacterize the IRA because the conversion taxes are paid on the value of the IRA at the date of conversion. You will be paying taxes in April on a value that no longer exists.

The conversion can be reversed any time before the due date for the tax return for the year of the conversion, including extensions. The extension date can be used even if the taxpayer files the return by April 15. This means if you converted an IRA in 2008, the recharacterization can occur any time up to Oct. 15, 2009, regardless of when the 2008 return is filed. If the return was filed and taxes on the conversion paid, an amended return can be filed to get a refund of the conversion taxes.

Once recharacterized, the IRA can be left as a traditional IRA, or in the future it again can be converted to a Roth. The second conversion cannot be made in the same year as the original conversion. A second conversion also cannot occur until more than 30 days have passed since the recharacterization.

There are a couple of times when a taxpayer might want to reverse a conversion.

One reason to recharacterize is that income for the year (excluding the converted amount) unexpectedly exceeds $100,000. A conversion is not allowed when modified adjusted gross income is more than $100,000. When income exceeds $100,000 a taxpayer who wants the benefits of a Roth IRA has to recharacterize and wait for another year when the $100,000 threshold isn’t breached.

The other reason to recharacterize as we said is that the value of the IRA declined after the conversion.

Before beginning a conversion plan, check the fees charged by your IRA custodian. Some will charge for each conversion and recharacterization. Also, be sure the custodian does not impose restrictions in addition to those of the IRS. If your custodian could impede your plan, switch custodians. Another point: IRA custodians often are backed up with requests near the end of the year and cannot process them all promptly. Some transactions IRA owners want done by Dec. 31 are not completed because of the back log. Make your decision and process your paperwork early.

Posted 10-17-2008 6:05 PM by Bob Carlson