Before Your Roth IRA Conversion: Have You Considered Taxes?

by Miranda Marquit · 10 comments

We are rapidly approaching the fifth month of 2010. This year is notable for many things, and one of those is that this year it is possible for anyone — no matter his or her income — to convert a traditional IRA to a Roth IRA. There are some advantages to having a Roth IRA, one of those being that when it comes time to withdraw funds, you can do so tax free. Earnings in a Roth IRA grow tax free (but the contributions you make to a Roth IRA are after-tax to make up for this).

While the future tax implications might be tempting, especially if you believe you will be in a higher tax bracket. However, it is also important to consider the tax implications that come now. Here are some of the things to keep in mind with regard to taxes when you make a Roth IRA conversion:

  • Your rollover to a Roth IRA is like a distribution: The money contributed to a traditional IRA came out pre-tax, lowering your taxable income. When you convert, the process is treated like a distribution from your traditional IRA, meaning that you have to pay income taxes on that money. Therefore, your Roth conversion will increase your tax bill. You can spread your tax hit over your 2011 and 2012 returns to reduce the initial impact, but the tax hit is still there.
  • You could end up in a higher bracket now: Because the distribution from your traditional IRA for rollover into a Roth is treated as income, it might actually put you in a higher tax bracket for 2010, depending on how much you convert, and how close you are to the next tax bracket.
  • Higher AGI = fewer deductions and credits in some cases: There are some tax deductions that you get as a percentage of your adjusted gross income (AGI), and some deductions and credits that phase out when you reach a certain income level. The increased income due to your Roth IRA conversion might actually put you over the limit in some cases, putting you on track to phase out. One example relates to those who are used to deducting medical expenses. If your expenses are at least 7.5% of AGI, you can deduct them. However, if your AGI increases, it may mean that your expenses may no longer account for 7.5%, and you become ineligible for the deduction.

A Roth conversion is not so simple isn’t it?

Just like any financial decision, what you decide to do about your retirement and the Roth IRA conversion is a very personal choice. However, many people have a knee-jerk reaction that conversion is desirable in all circumstances. There might be some cases in which the realities of Roth IRA conversion actually make it undesirable. Before you decide on a Roth IRA conversion, consider your financial situation, and consult with a tax professional who can help you work out the implications. Only after you have studied various scenarios and analyzed the numbers should you make a decision about the advisability of a Roth IRA conversion in your financial case.

So I must ask you. Are you planning to make the switch, or have you even thought about it yet?

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{ read the comments below or add one }

  • marci357 says:

    My tax man says No, there is no reason for me to.
    I’ll still be in a low tax bracket then (unless I win the lottery – lol)
    so there will be very little taxes due in retirement.
    And it helps lower my taxable amount now, which I am all for 🙂

  • Mike says:

    Great post.

    It’s because of things like this that I wonder more and more why no one questions the “must convert to a Roth” mantra these days. I know there are no limits on what can be converted anymore, but the taxes and fess haven’t been removed.

    I wonder, does it make sense to have both a Roth and a traditional IRA or 401(k)? I’ve been thinking about opening a Roth and funding that after funding my 401(k). I figure that when I retire, I can draw down the 401k, since that has minimum required distributions and save the Roth for when the 401k is gone or possibly leave it to my heirs. Any thoughts on that idea?

    • JoeTaxpayer says:

      Mike, a few of us have been (questioning the wisdom of Roth conversions.) For me, it’s less about the conversion, per se, and more a concern about the mania surrounding wholesale conversions of all of one’s pretax accounts.
      What you suggest is close to my thinking. Here’s how I’d modify it – get familiar with your marginal tax rate. One of the better charts is at under “reference room.” While you are working, if you look at your rate, it may make sense to use pretax accounts to keep you from going into the next tax bracket, but not so much that you are well below the line. A good number of people can use this strategy to stay right at the 15% bracket.
      Then at retirement, of course you’ll take the RMDs. But then take just enough more, and convert to Roth just to top off that bracket you’re in. This will minimize taxes over your lifetime and avoid the risk that you’d pay too much now to find you are retired and paying only 10%.

  • Eric says:

    Because of our income level, our contributions to traditional IRAs were not tax deductible and therefore a conversion to a ROTH doesn’t cost us any money. My hesitation now however is that you can only do a conversion ONCE (at least that’s my understanding)… so what happens during the next several years when I still cannot contribute to a roth directly and need to contribute to a traditional IRA.

    • JoeTaxpayer says:

      Eric – you can convert as much as you’d like. You may be confusing two issues.
      Starting this year, one can convert regardless of income. But – only conversions made this year may be split in two and taken as income in 2011 and 2012.
      This rule may not impact you if you had no account growth.
      In 2011 and beyond, one can convert what they will, and pay tax in that tax year.
      For what it’s worth, a very few select people should convert it all at once. One of the best strategies is to “top it off” only converting enough to fill the bracket you are in, but not go to the next. This requires a bit of attention and paperwork, but it’s not rocket science.

      • Miranda Marquit says:

        Thanks, Joe. It’s nice to have you around 🙂 I believe (correct me if I’m wrong) Eric is right, though, that he won’t be able to contribute anything new to his Roth if he is beyond the income limit. And, of course, he can’t contribute to the Roth this year, either. It’s just for the rollover.

        • JoeTaxpayer says:

          If he is over the income limit to deposit to Roth, he can make a Traditional IRA deposit and immediately convert. He might owe tax on the few cents that accrue during that time. I know this is odd, but so long as one has no pretax IRA money, it’s just an extra step. Make sense?

  • Pinyo says:

    As much as I want to, we will not convert our IRAs due to tax considerations.

    • MoneyNing says:

      I could have written the exact comment 🙂 I want to do it, but the tax implications don’t seem to make sense for our family.

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