All of a sudden it seems like everybody in the financial planning world is talking about Roth IRAs and Roth conversions. If fact, an article in Financial Planning magazine recently proclaimed 2010 “The Year of the Roth.”
So What’s the Big deal?
Well as of 2010 the rules of conversion from traditional IRA’s to Roth IRA’s have changed so that everyone, regardless of income is eligible to convert. But does it make sense for you? Well it depends.
I’m sure you are not surprised by that answer! While financial modeling tools are very important in assessing the financial benefits (or not) of conversion, assessing each person’s unique circumstances is just as important. Two people with near identical balance sheets may behave differently due to differing circumstances, perspectives, and goals. One size definitely does not fit all!
So it is important to have a filtering process to consider factors such as The Duration of the investment:
The longer your money remains invested the greater the potential value after conversion. Typically you will need at least 10 years to make the conversion worthwhile.
Current future tax rates: If you expect to pay higher taxes in retirement that you would pay now that will make conversion look good. Having money in a Roth account could give you some control over your tax bracket in retirement by avoiding a higher bracket when taking needed income from a Roth. And Roth’s do not have those pesky RMD’s which could add to the benefits of tax deferral over the life of your estate. Of course factoring in potential tax law changes makes any tax analysis dicey at best.
Cost of Converting: Conversion results in additional income that increases your taxes now so the cost of these taxes must be factored in. The 2010 option does allow you to spread this cost over the 2011 & 2012 tax returns, resulting in a very short term loan from the IRS. But if you have to pay the taxes out of the balance of the IRA, then you lose the value of future deferral and that is not a good idea.
The modeling of an IRA conversion is very complex because it involves many known and unknown factors. Fortunately, the law allows for partial Roth conversions and even lets you change your mind until October 15 of the year after the conversion!