Gary Charles, Retirement Planning Director, 1^st Global

May 15, 2004 -- If you hold a Traditional, Rollover, or SEP IRA, you may be able to convert all or a portion of those assets to a Roth IRA (assuming your adjusted gross income is $100,000 or less¹). But should you make the conversion? A conversion, full or partial, can provide significant tax savings even if the owner of the IRA has only a very short life expectancy. While a conversion requires you to include the taxable assets you are converting in current income, it enables you to avoid future federal taxes on any subsequent IRA earnings and withdrawals (provided certain conditions are met). This opportunity for federally tax-free growth and distributions can substantially increase the value of your retirement savings down the road. The answer as to whether YOU should convert is…maybe.

The potential benefits of converting to a Roth IRA include:

• A lower tax bill in the future.
• The ability to invest a larger dollar amount in a federally tax-free vehicle by using other savings to pay tax on the conversion.
• Your money may be invested in a tax-free vehicle for a longer time by avoiding minimum required distributions (MRDs) after age 70½.
• A reduced estate tax when you pay income tax on your IRA before you die². Also, upon your death, your Roth IRA will pass to your beneficiaries free from federal (and often state) income taxes. However, estate taxes continue to be payable.

Converting to a Roth IRA may mean accepting a higher tax bill now in exchange for a potentially lower tax bill later. Your strategy should depend on the answers to the following questions:

• How will you pay the conversion tax? To allow as much money as possible to grow tax-free, it is best to pay any applicable taxes due on the conversion out of your non-retirement savings. If you draw from your IRA savings, you will have to pay the taxes on the IRA distributions and you might also have to pay an early withdrawal penalty, which could make the conversion less attractive. If you find that converting all of your existing IRA assets to a Roth IRA presents too large a tax burden, consider converting just a portion of the IRA, resulting in a tax payment you feel is manageable.
• How long can you leave money within the Roth IRA? In general, the longer the better. A longer holding period gives you more time to benefit from federally tax-free distributions if you meet certain five-year aging rules and other qualified withdrawal requirements.
• Will your tax rate be higher or lower when you use the money? If you think your tax rate will be the same or higher than your current rate when you withdraw your money, it may make sense to pay the tax liability now – in exchange for the opportunity for tax-free growth and tax-free distributions in the future.
• In the past have you made nondeductible contributions to your IRA? You won’t have to pay taxes on this amount at the time of conversion, thus making the conversion less expensive.

¹Converted amounts are not included in your adjusted gross income when determining eligibility. If you are married filing jointly or single, your AGI cannot exceed $100,000 in the year that you convert. If you are married filing separately, you are not eligible to convert unless you have lived apart from your spouse for the entire taxable year.

 ²It is important to note the estate tax savings from a Roth conversion come from the fact that you’ve already paid the income tax, not from any special estate tax rule that applies to Roth IRAs. Effectively, the size of your estate has been reduced by the amount of tax you paid on the conversion dollars. Thus, you have a smaller estate even though the value of what you are passing to your beneficiaries is no smaller than if you had a regular IRA.

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