Roth IRA conversion

If you have a Traditional IRA, you can convert part or all the account to a Roth IRA. You pay taxes as if you withdrew the entire amount converted, but without any penalty for early withdrawal; in return, the money will grow tax-free in the Roth IRA, and you will not pay any tax on that withdrawal if you meet the Roth IRA rules. The gain or benefit depends on your current marginal tax rate, your expected marginal tax rate in retirement, and how you would otherwise invest the funds that you use to pay the taxes.

How to Convert
With Vanguard, to convert, you buy shares (or open a new account) in your Roth IRA, and fund it by "selling" shares in your Traditional IRA. If you convert shares in the same fund, you have not actually sold anything, so Vanguard will not charge a purchase fee or redemption fee on the conversion. Likewise, with other providers, notify the provider of which amount you want to convert.

You can undo a conversion by recharacterizing your conversion through October 15 of the year after you made the conversion. This treats the conversion as if it never happened, giving you a refund of the taxes if you have already paid them, and you can re-convert again later, so you may want to consider recharacterization if you converted and the value of your IRA declined substantially.

Rules of Thumb
If you expect to be in a lower tax bracket in a future year, wait until that year to convert. Likewise, if converting the whole IRA would push you into a higher tax bracket, convert only as much as will keep you in the current bracket, and convert the remainder in future years.

If your IRA contains substantial non-deductible contributions, convert as soon as possible.

Otherwise, compare your current marginal tax rate and your expected marginal tax rate in retirement, and consider where you would invest the money for the tax payment if you choose not to convert. Conversion is less attractive if your retirement marginal tax rate is lower than your current marginal tax rate, and more attractive if the tax payment would have to be invested in an inferior investment.

If your current marginal rate is lower than your expected retirement tax rate, you should convert in preference to any investment except a matched contribution to a retirement plan. If the rates are equal, max out your Roth contribution in preference to converting, but convert in preference to maxing out your 401(k). If your current rate is slightly higher, max out a decent 401(k) or Roth in preference to converting, but convert in preference to investing in a taxable account. If your current rate is much higher, do not convert.

New conversion rules for 2010:
 * Beginning in 2010, the modified AGI and filing status requirements for converting a traditional IRA to a Roth IRA are eliminated.
 * For 2010 only, you may choose to pay taxes on conversion either all in 2010 or in equal amounts in 2011 and 2012.

Calculations
These examples are based on converting $10,000 in a Traditional IRA, when you will retire in a 25% tax bracket. We also assume that every $1 in your tax-deferred or tax-free account will grow to $5 when you retire (becoming $3.75 after tax in a tax-deferred account), and $1 in a taxable investment will grow to only $4 because you will pay tax on dividends and capital gains.

If you do nothing with the Traditional IRA, it will grow to $50,000, and you will have $37,500 to spend in retirement. If you convert, you will have $50,000 in retirement, a gain of $12,500, but you will lose the benefit of investing the money you pay in taxes.

If you convert in a 15% tax bracket, the tax loss is only $1500. If you could have contributed that $1500 to your Roth, you will lose $7500 in retirement, for a net gain of $5000. Thus, you should convert in preference to funding a Roth.

If you convert in a 25% tax bracket, the tax loss is $2500. If you could have contributed that $2500 to your Roth, you will lose $12,500 in retirement, which is break-even; it is better not to convert just in case you find yourself in the 15% tax bracket in some future year and can convert then. If you could have invested $3333 in a 401(k) with investments just as good as in your Roth, which costs $2500 after tax, you will lose $16,667 pre-tax, which is $12,500 after tax, so this is also break-even. The same calculation also applies if you withdraw $3333 extra from your IRA to pay the taxes, instead of eliminating a $3333 contribution to the 401(k); it is again break-even. If your 401(k) is more expensive than your Roth (which most are), you should convert before maxing out your 401(k).

If you convert in a 28% tax bracket, the tax loss is $2800. If you could have invested $3889 in your 401(k) (which is $2800 after tax), you will lose $19,444 pre-tax, which is $14,583 after-tax, so unless your 401(k) is so bad that it costs you the 14% difference between $14,583 and $12,500, you shouldn't convert. However, if the choice was to invest $2800 in a taxable account, that would only grow to $11,200. Thus the conversion is better than taxable investing.

If you convert in a 33% tax bracket, the tax loss is $3300. You could get $13,200 by investing $3300 in a taxable account, so you don't want to convert at all with this much of a tax bracket difference.

Other considerations
If you might retire before taking Social Security, you are likely to be in a very low tax bracket in the first years after retirement, as some of your income will not be taxable unless it all comes from IRAs and pensions. Therefore, you might wait until after retirement to do the IRA conversions, as you will pay less in taxes.

If you will be taking Social Security when you retire, and your retirement income would apparently put you in a low tax bracket, taxation of Social Security benefits may give you a much higher marginal tax rate. This is an advantage for converting to a Roth, as IRA withdrawals are counted as income for determining how much Social Security is taxable, while Roth withdrawals, which are based on already-taxed money, are not income.

Recognize two cautions regarding taking conversions during retirement:
 * 1) If you are drawing Social Security, a Roth IRA conversion could result in a one-year increase in the taxable portion of your Social Security benefits. Total income for Social Security purposes is defined as half of your benefits plus any other income, including tax-exempt income. This income level determines the taxable percentage of your benefits (0%, 50%, or 85%). Keep in mind that future distributions from a Roth won't affect the taxation of your Social Security benefits, which may help you in the long run.
 * 2) Medicare premiums depend on your modified adjusted gross income (MAGI) from the previous two years (for example your 2008 MAGI determines your 2010 premiums). A Roth conversion reported in a given year will increase your MAGI two years hence. Most retirees pay the standard Medicare Part B premium—about 25% of the total cost—with the U.S. government paying the rest. For affluent individuals, if your MAGI exceeds certain levels (for 2010, $85,000 MAGI single; $170,000 joint) your premium will likely be higher.

If you are eligible for tax credits now, find your true marginal tax rate, not your tax bracket, and use that in the decision whether to convert. If you are in the 25% tax bracket but increasing your income by $1000 causes a tax credit to phase out and costs you $50 in credits, your actual marginal tax rate is 30%.

A Roth IRA is exempt from required minimum distributions while you are alive. Therefore, if the Roth conversion is close to break-even but you might be forced to take distributions from your Traditional IRA which are more than you need to live on, there is an advantage to conversion; you will keep more money growing tax-deferred for longer.

Converting with Non-Deductible Contributions
If you have non-deductible contributions in your IRA, you do not pay tax on the amount of non-deductible contributions. If you make a partial conversion, you must prorate your deductible and non-deductible contributions to all IRAs (including SEP and SIMPLE IRAs) as of December 31 of the year you convert. For example if you made $5000 in non-deductible contributions, and you converted (or withdrew) $3000 and had $7000 left in your IRAs at the end of the year, for a total of $10,000, then half of the $3000 is taxable. To compute the taxable amount of your conversion, use IRS Form 8606.

Since the amount of non-deductible contributions does not increase as the IRA grows, there is a tax advantage to converting quickly. If you wait for your $10,000 IRA with $5000 in non-deductible contributions to grow to $20,000 before converting, you pay tax on $15,000 rather than $5000, tripling the tax but only doubling the amount converted.

In particular, if you have no Traditional IRA now, and are eligible to convert a Traditional IRA to a Roth but not eligible to contribute directly to a Roth, you should contribute to a non-deductible Traditional IRA and then convert immediately; you will pay no tax on the conversion (except for market fluctuations in the few days between contributon and conversion), and thus you have effectively contributed to a Roth. (If you already have a Traditional IRA which you do not want to convert, then you cannot use this technique to make a tax-free contribution to a Roth, as any partial conversion will be partly taxed.)

Links

 * Fairmark's Roth IRA Guide
 * IRS Publication 590, IRAs