For many retirement savers, the idea of converting traditional IRAs into Roth accounts is attractive. The reason: withdrawals from earnings during retirement are federal income tax-free (as long as you are over 59 1/2 and have had the account for at least five years).
Should you convert? In many cases, the answer is yes. But there are some things to carefully consider before making a final decision.
Do You Have the Money to Pay the Taxes on the Conversion?
When you convert your regular IRA to a Roth, you will have to pay tax on any earnings and pre-tax contributions. This is in lieu of paying taxes upon later withdrawals from the Roth account. You should not tap your IRA to pay the conversion tax, however. If you do so before age 59 1/2, you will generally owe a 10% penalty on that amount. Plus you'll permanently give up the opportunity for tax-free Roth IRA compounding of that amount.
And don't think that you can avoid the conversion tax by just rolling over an amount equal to your after-tax (nondeductible) contributions. Each dollar you roll over from a regular IRA is considered a "blended" dollar. Therefore, a percentage of the amount rolled over into the Roth account will be taxed no matter what (except in the unlikely event that your IRAs are worth less than the amount of your after-tax contributions).
Will the Rollover Disqualify You for Important Tax Benefits?
The conversion income could push you into a higher tax bracket and disqualify you from other tax benefits such as the child tax credit and the higher education tax credits.
How Much Time Do You Have Until Retirement?
Generally, the older you are, the less sense it makes to convert a traditional IRA to a Roth. You'll have less time to make up for what you lost in taxes on the conversion.
Do You Plan to Leave All of Your IRA to Your Heirs?
One case in which it makes sense for an older traditional IRA holder to transfer funds to a Roth IRA is when he or she is planning to leave the money to heirs. Why? Two reasons. First, unlike traditional IRAs, Roths require no minimum withdrawals during the life of the IRA owner. If the surviving spouse inherits the Roth account, he or she need not take any minimum withdrawals either. With a regular IRA, you must begin taking taxable withdrawals from that account no later than the year after you turn 70 1/2. So you lose out on the chance for that money to continue to compound without paying taxes. That can mean a lot less money for your heirs.
Secondly, conversion to a Roth will reduce your taxable estate by the amount of income tax you pay to convert. This can reduce estate taxes for your heirs.
Will Your Income Tax Bracket Drop After Retirement?
The clearest case in which converting from a regular tax-deductible IRA to a Roth IRA does not make sense is when you expect to drop into a much lower income tax bracket after you retire (say, from 25% to 15%). Why? You will have to pay income tax on the conversion at your current high rate. Instead, let the money compound in your regular IRA and pay taxes at your lower rate in retirement. However, if your tax rate is only expected to drop a few points after retirement (say, from 28% to 25%) or even stay the same or go up, conversion is probably the right move.