Is a Roth IRA Conversion a Good Idea?

This article assumes that you are familiar with the features of a Roth IRA and the opportunity to convert your traditional IRA to a Roth IRA. Refer to my November 11, 2009 post for some background information. This post reviews a few “rules of thumb” to determine whether you might be a good candidate for a conversion. There is no mathematical benefit to a conversion if your income tax rate in retirement is the same as the tax rate for the year of conversion and you pay the conversion tax with IRA funds. Some other factor is needed for the conversion to be favorable, such as:

• You have non-IRA funds that can be used to pay the conversion tax.
• Your average tax rate will be higher in the future (when you retire and draw upon IRA funds) than your marginal tax rate at conversion.
• You have a net operating loss carryover (but not a capital loss carryover) or an unused charitable contribution that could offset some of the conversion income.

In addition, if you have one of the following characteristics, you may find the Roth conversion useful:

• You don’t need the IRA to fund retirement expenses and can leave it to your heirs.
• Your proportion of nondeductible IRA tax basis to the total value of all your IRAs is over 50%.
• Your IRA assets are temporarily depressed in value or are expected to greatly increase in value in the future.

However, a Roth IRA conversion is not a good idea for most middle- and upper-middle-income people. Such people need to rely on their IRA to fund retirement. The marginal tax paid when converting the traditional IRA will almost always be higher than the average tax paid in retirement when taking IRA distributions. Even if tax rates increase in the future, those increases will mostly affect the upper tax brackets applicable to very high income earners. Not many taxpayers in the 28% marginal bracket today will be pay an average 28% rate in retirement because the income tax brackets are indexed for inflation, and the average of lower brackets will always be less than the highest rate bracket to which you are subject. Therefore, be very careful of making a Roth IRA conversions if:

• You are not consistently in the top income tax bracket, and if not,
• You will pay conversion tax at a marginal tax rate above 15%.