The opportunity to convert an existing regular IRA to a Roth IRA may be the single biggest upside to the stock market’s extended slide. The younger you are and the more aggressive your investment strategy, the more likely it is that a conversion to a Roth IRA will make sense for you.
You may already be aware of the key difference between a regular IRA and a Roth IRA. At a very high level, a regular IRA provides for tax-deferred growth whereas a Roth IRA gives you tax-free growth. All else equal, we’d all prefer tax-free growth, of course. Here’s everything you need to know about Roth Conversions
Contributions to a Roth IRA are limited and are not deductible
Trouble is, income limitations prevent everyone from being eligible to contribute to a Roth IRA. During 2009, if you’re single and make more than $120,000 ($176,000 combined with your spouse, if you’re married), you can’t contribute a dollar to a Roth IRA. Furthermore, those who can make a Roth IRA contribution can’t deduct it – that’s your key upfront sacrifice for the many future years of tax-free growth.
A Roth Conversion allows everyone access to a Roth IRA
Let’s first define what a Roth conversion is: the transformation of your retirement account from tax-deferred to tax-free status. You effectively move money from an existing regular IRA or former employer’s 401k account into your Roth IRA. The cost to do this conversion is the payment of regular income tax on virtually the entire amount you convert. (You’ll pay tax on 100% of the converted amount unless you previously made non-deductible contributions).
Roth Conversion restrictions are going away
Through the end of 2009, conversions are only available to those people who earn less than $100,000 and have filing statuses other than married, filing separately. However, both of those restrictions are eliminated at the end of the year. As a result, anyone who wishes to contribute to a Roth IRA but whose income level is too high can make a 2009 contribution to his/her regular IRA and simply convert part of their account in 2010.
Why converting your Roth IRA could make sense today
If you’re confident your 2009 adjusted gross income will be less than $100,000, you don’t have to wait until 2010 to convert. Furthermore, you can take advantage of market downturn, as I referenced earlier. Here’s a simple example:
Say you invest in stock and you accumulated 300 shares of Johnson & Johnson stock (JNJ) over the years. If you converted your shares during April of 2008, when JNJ was trading at about $67 per share, you’d have converted $20,100 of stock. Assuming you were in the 25% tax bracket, you would have owed about $5,000 in taxes on the conversion.
In April 2009, JNJ was trading at about $51 per share. If you converted the stock then, you would have converting $15,300. If you were in the same 25% tax bracket, you’d owe just over $3,800 in tax, not $5,000, for a permanent tax savings of $1,200. In either conversion, you retain ownership in the long-term potential price appreciate of JNJ, yet in the latter case you’ve successfully timed the market from a tax perspective.
It’s certainly possible that stock prices could go lower from here and that a further delayed conversion could be even more lucrative from a tax perspective. Nonetheless, a conversion could make more sense for you today than at any time previously.
Take advantage of your youth
The big upside of voluntarily paying taxes (since you don’t have to convert), is the tax-free appreciation of your converted investments. The longer the amount of time you have until you plan on taking your money out (ideally retirement), the greater the odds that a Roth IRA conversion will make sense.
In addition, the better your investment performance between now and retirement, the greater the upside of converting to a Roth IRA. Still, it makes sense to run the numbers. Importantly, it seldom makes sense to convert to a Roth IRA if you don’t have the money available to pay the tax on conversion. Using money from your IRA to pay the tax almost never makes financial sense.
Keep in mind that it’s not an all-or-nothing proposition. If you want to convert your retirement account but just don’t have the funds set aside to pay all the taxes, consider converting some of your account. You can always do some more next year.
Michael B. Rubin is the author of Beyond Paycheck to Paycheck and the blog of the same name. He is the President of Total Candor, a financial planning education company.