NEW YORK To Roth or not to Roth? As it turns out, you can sort of have it both ways.
You can convert a traditional Individual Retirement Account (IRA) -- with taxes deferred on the deposits and income tax paid on the withdrawals in retirement -- to a Roth, where instead taxes are paid up-front and no income taxes will be due again. And if it doesn't work out for you in terms of the tax burden or losses in the account, you can change your mind, because of some generous do-over clauses.
Ever since restrictions on conversions changed two years ago -- allowing higher-income individuals the choice -- there has been a flurry of Roth conversion activity, and still lots of hand-wringing over the decision to go for it or not. Seems a lot of people still just can't imagine paying taxes earlier than they have to -- now, as opposed to when they turn 70-1/2 and have to start taking money out of the accounts.
"It becomes a bit of a counter-intuitive analysis," says Marc Minker, a managing director at tax and accounting firm CBIZ MHM. "Most taxpayers say, ‘I don't want to write a big check.'"
With around $4 trillion in IRA assets, and only a small portion of that money in Roths, there may be a lot of people facing these decisions. If you're among them, here are six key issues to consider:
1. Convert only if you can pay the tax bill from outside your retirement accounts, otherwise, you're just eating away at your savings. Depending on your tax rate and what assets you're converting, that tax hit could be a third of the account's value or higher.
How big that bill will be depends on whether your IRAs were funded with deductible contributions, non-deductible ones or a combination. If you only own IRAs funded with non-deductible contributions, then you'll owe taxes on the earnings only (because you paid tax on the deposits already), and if you have only deductible contributions then you'll owe taxes on the full amount you convert that was contributed on a pre-tax basis.
If you contributed both ways, it gets a little complicated because all those assets are considered as one amount for conversion purposes -- a rule designed to prohibit you from cherry-picking -- so you'll need to figure out your tax hit based on the pro-rata share of each.
Online calculators such as this one from Schwab (link.reuters.com/quq37s) can help you figure out your tax bill in advance.
2. The longer you have until you need the money, the better the Roth conversion, thanks to the value of tax-free compounding. But timing isn't just about your age; it's about when you might need that money.
The less likely you are to spend down your Roth in retirement, the more valuable it is. And if you plan to pass that money on, the Roth has an even bigger advantage, since you don't need to take required minimum distributions on a Roth after 70-1/2, nor will your heirs need to pay income tax on it.
3. While converting to a Roth may be worthwhile even if your income tax rate remains the same, it is an especially good deal if you expect your income tax rate to be higher in the future than it is now. And the possibility of higher tax rates in 2013, especially for high-income taxpayers, has provided a new impetus to convert sooner rather than later.
Remember, though: Even if tax rates overall go up, your rate in retirement may be lower. It's best to diversify your portfolio for tax purposes by holding some assets in a traditional IRA and some in a Roth IRA.
4. While there are income limitations on funding a Roth (the phase-out starts at $107,000 for singles, and $169,000 for married filing jointly, for 2011), the removal of the income restrictions on converting to a Roth for those with modified adjusted incomes over $100,000 has led some financial planners to suggest that clients fund a non-deductible IRA and then convert it immediately to a Roth. "A lot of people are doing it," says Brooks Mosley, president of Security Ballew Wealth Management in Jackson, Mississippi.
5. Special considerations for this year's tax returns: If you converted any IRAs to Roths in 2010, and took advantage of the special rule allowing you to spread the tax due over two years, you'll owe half the tax on this year's return. If you converted in 2011, you'll also owe tax on that conversion at this tax season since there was no special two-year tax deal in 2011. Don't let this come as a nasty surprise at tax time.
6. The Internal Revenue Services allows you to undo your conversion in a process called "recharacterization." The biggest reason to recharacterize a Roth is if your investments go south. Say, for example, that you converted a $100,000 deductible IRA to a Roth, and the investments in it declined by 20 percent. You'd owe tax on the full amount, even though your holdings are now worth only $80,000. Ouch! To avoid that outcome, you simply recharacterize the account with your financial institution; the deadline for undoing 2011 conversions is October 15, 2012.
If you decide you want to try again, at that lower valuation, you could do so (you'll need to wait either 30 days after the recharacterization or until the tax year after the conversion, whichever is later). CBIZ's Minker explains that when he helps his high-net-worth clients convert to a Roth, he divides their portfolios into multiple different Roths, with different investments in them, so that he can undo a piece of the overall conversion if he has to, while leaving in place the new Roths that worked. "Eventually, it will work, or it may partially work," he says. "The philosophy is the same whether it's $100,000 or $1 million."
(The author is a Reuters contributor. The opinions expressed are her own.)
(Editing by Beth Pinsker Gladstone and Andrea Evans)