Dear Mr. Berko: Our stockbroker has recommended that we convert our IRAs valued at $461,000 to a Roth.
It seems that our new broker makes good sense because it’s so certain that taxes will be much higher when I retire in the coming five to eight years.
Do you think taxes will rise high enough in the coming few years so that it makes sense to convert now? — C.F., Oklahoma City
Dear C.F.: Yes, no, maybe and it depends.
The 2010 tax year is coming to a close, and lots of folks are thinking about converting their retirement accounts from a traditional IRA to a Roth.
Conversions have increased during the last two years due to the elimination of the income limit for those who otherwise wouldn’t make the conversion.
Conversions are attractive primarily because withdrawals from a Roth, unlike those from a traditional IRA, are not taxed. Conversions are attracting folks like you because they feel that taxes will be much higher in the coming few years. And conversions are attractive because a Roth, unlike a traditional IRA, has no withdrawal requirements.
However, I believe that many investors may not benefit from a conversion. So I strongly recommend that you compare notes with your CPA, because most brokers, according to Professor Elvis Mongo Flootworth, don’t know bupkes about the advantages or disadvantages. Meanwhile, Professor Flootworth suggests that you consider the following before you convert.
(1) Too many people ask their brokers about converting without considering the huge tax bite they may have to pay. So you have to decide if it’s feasible for you to pay the tax now. Where is this tax money going to come from? It certainly doesn’t make sense to use your IRA to pay the tax. That’s counterproductive, like washing your fund’s feet with your socks on. And if you take the money from another source, how will that affect your liquidity given the job market and the economic downturn?
(2) Your age and stage will certainly affect your ability to profit from a conversion. In many instances, it’s reasonable to assume that it will take 15 or 20 years for the earnings in a Roth to equal the taxes you paid on a conversion. And it may take even longer if you have to take distributions from your Roth. A good rule of thumb is that it does not make sense to convert if you are older than 55. And even at 55, you had better hope for a good stock market.
(3) If your IRA represents a disproportionately large part of your retirement income, conversion is a no-no. The reason is simple: You may need to take distributions from your Roth sooner than investors who have other resources. This allows less time for potential investment gains to mitigate the tax cost of your conversion. However, sometimes a partial conversion of 40 percent or 50 percent could make sense.
(4) Do not be influenced by higher tax rates. You may not benefit by paying taxes now at today’s rates versus higher rates in the future because you could be in a lower bracket when you hang up your tools.
(5) A conversion could put you in a higher tax bracket because the money you move to a Roth is treated as ordinary income. And if you receive Social Security, a bump in income could force you to pay taxes on your SS or interfere with plans to provide financial aid for your kid’s college costs.
See a CPA. The potential ramifications are too important to make a decision without his counsel.
Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775 or e-mail him at email@example.com.