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Should I Convert my Traditional IRA to a Roth IRA?

Due to recent market declines and the changes in conversion rules for 2010, there’s been a lot of interest in converting traditional IRAs to Roth IRAs lately.

What worries me is that some investors seem to be focusing entirely upon whether they can convert their IRA to a Roth without bothering to determine whether they should convert it.

In that vein, I thought it would be beneficial to point out three scenarios in which it might not make sense to convert a traditional IRA to a Roth IRA.

You Expect A Lower Tax Bracket in Retirement

If you expect your tax bracket in retirement to be lower than your 2011 tax bracket, converting is unlikely to be advantageous.

And no, the market being down from where it was in early 2008 does not change that fact. Paying, for example, 25% now is not better than paying 15% later, even if that 15% is on a larger total. (Remember the commutative property of multiplication? It still works.)

Please note that this means that the people who weren’t eligible in 2009 or prior years due to income restrictions but who will be eligible in 2010 (when the income restrictions are temporarily removed) are actually somewhat unlikely to be in the group who would benefit from a conversion.

You Don’t Have the Cash On-Hand

If you don’t have the cash available to pay the tax on the conversion, then it’s unlikely to be a good idea. If you use money out of the IRA to pay the tax, the amount you withdraw counts as a non-qualified distribution and will be subject to the 10% penalty if you’re under 59½. This is not a good thing.

You’re Seeking to Avoid RMDs

Something that gets mentioned frequently when discussing Roth conversions is that, unlike traditional IRAs, Roth IRAs are not subject to Required Minimum Distribution rules.

That’s true. But does it make sense to enact a Roth conversion (which is, essentially, a voluntary whole-IRA distribution) now in order to avoid Required Minimum Distributions later? I’m not convinced.

Not That Roth Conversions Are a Bad Thing…

Of course, the point of all this isn’t to say that converting your IRA to a Roth IRA is a bad idea. Many investors really would save money in the long-run by converting. But please don’t do it on the assumption that it’s automatically beneficial just because you’re eligible. 🙂

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  1. Keep in mind our tax tables are not set in stone.

    Another reason to consider converting to a Roth IRA is because you believe tax rates will increase. You may be in the same “bracket” in retirement i.e. same relative income, but end up paying a higher tax rate due to tax increases.

    Given the historically low tax rates we have today, the amount of current government spending and our nation’s deficit, it’s reasonable to assume some level of tax increases especially in the upper brackets.

    The strategy for some, then, would be to lock in their tax rate at these relative lows while enjoying some of the other benefits that come with a Roth IRA

  2. Good post and thanks for the link! I think of the stronger points made was cash on hand to pay for the tax on the conversion. If you are taking it out of the account, the conversion is almost pointless because it will most likely take you years to recoup it.

  3. Great Post! I think too many magazines and PF Bloggers assume the conversion is a must, rather than think it through whether it really appplies to everyone.

  4. How about the concept of converting a portion of it? It’s doesn’t have to be all or nothing. By converting some of your traditional IRA you can better tax diversify in retirement. This might also help you be in a lower tax bracket from the standpoint of your traditional IRA and then you can supplement your income with tax-free money from your Roth.

  5. Evolution: Great point about partial conversions.

    Incidentally, I wrote a guest post for Moolanomy about tax diversification just yesterday:

    Thanks for bringing it up in this context as well. 🙂

  6. I’ve studied this and written multiple posts on my site as well as guesting on the conversion topic.

    One thing that I can’t escape. The numbers. I find median net worth at retirement to be on the order of $250K. Call it $400K if you wish, to get to the 75% percentile. A chunk of that is surely one’s home, $150K or so. So even at $250K in pretax retirement accounts, a 4% withdrawal rate is $10K/yr. My friend, this is the zero bracket. STD deduction and exemptions add to $18,700 for a married couple. $467K gross pretax money to withdraw the $18,700/yr, and stay in zero bracket.
    This analysis is the subject of an upcoming post of mine, but here’s my twist; the conversion would likely benefit so few that the discussion of it is certainly overblown. How many people will convert at 25%, only to find they retire in that zero bracket and paid the tax for nothing? For what, to avoid the risk of paying 28%?
    I don’t doubt rates are sure to rise, but do you believe that these lower brackets, the zero and 10% will both be done away with?

  7. “How many people will convert at 25%, only to find they retire in that zero bracket and paid the tax for nothing? For what, to avoid the risk of paying 28%?”

    Indeed. That’s exactly what I fear is going to happen next year.

    I’m pretty convinced that most people can handle the basics of investing on their own. (Put together a portfolio of index funds, and hold them forever.) But when it comes to the tax aspects, I find that most people really need help.

    Looking forward to your post. 🙂

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