In January 2002, the Coen brothers made their first foray into Super Bowl advertising by directing a commercial for H&R Block. Why did they do it?
“We have always been fascinated with the mysteries of the tax code,” the brothers explained with apparent sobriety, “and with the people who struggle so mightily to plumb its depths.”
For years, tax laws have allowed taxpayers to transfer funds from their traditional IRA to a Roth IRA (“Roth conversion”). But only taxpayers with a modified adjusted gross income of less than $100,000 were eligible. Beginning in 2010, anyone can convert all or a portion of their IRA to a Roth IRA. Also, the taxes due on the conversion can be delayed until tax years 2011 and 2012.
These factors have led many financial publications and financial advisors to eagerly recommend that investors convert to Roth IRAs. The appeal is that, unlike traditional IRAs, funds in a Roth IRA are not taxed when withdrawn—either by the owner or his or her heirs. Also, Roth IRAs are not subject to required minimum distributions while the original owner is alive. Therefore, the funds continue to grow tax-deferred.
But converting to Roth IRAs isn’t a smart move for everyone. Does it make sense for you?
In our opinion, a Roth conversion makes sense for people in these circumstances:
- Anyone in a low tax bracket, because the tax cost of a conversion is low.
- Business owners with a loss. If you own an S corporation and have a loss, you can offset the tax from the Roth conversion with the loss.
- Investors who don’t expect to draw on the account for many years, if at all. If you plan to pass the money to your heirs, do them a favor and pay the taxes now. You can even do the Roth conversion and have them pay you back for the taxes on the conversion.
Even if the conversion makes sense, here are some issues that might affect your decision.
First, doing a Roth conversion raises your income in the year you do it. This has several impacts:
- For a $100,000-conversion, the Roth IRA owner will owe about $30,000 in income taxes (5 percent state and 25 percent federal). That’s a tough pill to swallow.
- The additional income from the Roth conversion may put you in a higher tax bracket for a year, affect your ability to take various tax deductions and credits, or push you into Alternative Minimum Tax territory. Increasing your income might also reduce eligibility for college loans and scholarships.
- Furthermore, increasing your income might increase taxes on Social Security benefits or increase Medicare charges.
Other issues to consider:
- If you are eligible now, it may make sense to do a Roth conversion in 2009 rather than to wait until 2010. Stock market values are still down from 2007, so the conversion is relatively less expensive. Assuming that the market goes up in 2010, you’d want to lock-in the Roth earlier. And what if Congress passes a federal tax increase for 2010?
- Don’t take cash from your IRA to pay Roth conversion taxes. That would be robbing your investment. In addition, if you recharacterize the Roth conversion (see below), the funds taken from the IRA to pay the taxes cannot be re-deposited into the IRA.
- If you change your mind, you can “recharacterize” your Roth. Recharacterize is a fancy word for “undo.” Why would you recharacterize? If the market declines the year after conversion, you can recharacterize and complete a new Roth Conversion and pay less tax. As with all things involved with IRAs, complex rules apply to a recharacterization.
Despite the hype, a Roth conversion does not make sense for many people. But it’s always worth taking a look.