Would you benefit from a Roth IRA conversion?

Roth Nest Egg

A Roth IRA conversion seems like it might be a good idea, but what are the pros and cons and what do you need to know?

We believe that most investors should consider having a Roth IRA as part of their overall retirement plan because they offer tax-free growth potential and withdrawals,1 which has the potential to help minimize taxes and maximize retirement savings. But Roth IRAs have income restrictions, so not everyone has access to one today.

There's good news. If you've been shut out of a Roth IRA because your income is too high, you now may finally be able to have one. On January 1, 2010, the income limits for converting traditional, rollover, SEP, and SIMPLE IRAs, and 401(k) or other workplace savings plans with former employers, to a Roth IRA were removed. Before this change, only people—single or married and filing jointly—with modified adjusted gross incomes of $100,000 and below could convert. (There are still income limits for contributing to a Roth IRA in 2010 and beyond.)

Factors to consider before converting

The decision to convert needs to be made with care and should include a consultation with your tax advisor. Generally, it may make sense to convert if you:

  • Expect higher taxes in the future
    If you think that you'll be in a higher tax bracket (combined federal, state, and local taxes) after you retire, or if you plan to leave a substantial amount of your retirement assets to your heirs, you may want to consider a Roth IRA conversion. That's because you may pay lower taxes now than if you waited until retirement to begin taking taxable withdrawals. Also, if you expect your income to be lower than usual this year, or if the value of your non-Roth retirement accounts has declined (and you expect it may increase), it may make sense to convert.
  • Have a long investment time frame
    The relative benefits of conversion will increase the longer your money remains in the Roth IRA. Generally, conversion may not make sense if your time horizon is less than five years as amounts withdrawn are subject to a 10% penalty.
  • Can pay the taxes on the conversion
    We believe that, in most cases, you should avoid using proceeds from the conversion to pay the tax costs. In fact, we consider this one of the most critical factors when considering a Roth IRA conversion. Why? Because using proceeds reduces the amount that can potentially grow federally tax free in the Roth IRA, and offsets any tax savings that you may gain by converting. In addition, if you're under 59½, you'll pay a penalty, which will likely further reduce any benefit you might have received from the conversion. Instead, consider using cash or other savings held in nonretirement accounts to pay the tax liability.

Special option for paying taxes on 2010 conversions

If you convert this year, you may get a bit of a break. As long as you don't withdraw the amount you convert from the Roth IRA before 2012, you can include half of the conversion in your 2011 return and the other half in your 2012 return. While spreading out the tax bill from your conversion over two years may sound appealing you should think carefully about the pros and cons. For instance, it may make it easier for you to come up with the money to pay the taxes on the conversion over multiple years. Plus it allows the potential for the Roth account to grow tax free immediately while the taxes on the conversion have been deferred. On the other hand, if you defer taxes, keep in mind that tax rates could go up in 2011 and 2012 or your income may be higher than expected. This may make your deferred tax liability higher than if you had paid it all at once.

How much to convert?

If you determine conversion is right for you, the next consideration is "how much?" For example, as discussed above, you're more likely to benefit from a Roth IRA conversion if you can pay the tax cost for that conversion without using the proceeds. Therefore, one rule of thumb is to convert an amount based on the taxes you can afford to pay using non-retirement accounts. Additionally, even if you can afford to pay the taxes on the entire amount, you still might want to consider partial conversions over several years so the income from the conversion is not taxed in a higher bracket than your current one.

Conclusion

While a conversion does finally allow many high-income investors the opportunity to have a Roth, it's important that you analyze your situation and are comfortable with your decision. (See below for a summary of some of the common situations where an investor may benefit from a Roth IRA conversion.) It does ultimately come down to your assessment of the tax cost. How much tax will you pay if you convert now versus what you expect to pay when you withdraw the money during retirement?

Roth table

Next steps


Investing involves risk, including the risk of loss.

1. A distribution from a Roth IRA is tax free and penalty free provided that the five-year aging requirement has been satisfied and at least one of the following conditions is met: you reach age 59½, die, suffer a disability, or make a qualified first-time home purchase.

Each customer's situation, needs, priorities, and preferences are different. The decision to convert should always be made by the customer in full consultation with a tax professional.

The tax and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Fidelity does not provide legal or tax advice. Fidelity cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Fidelity makes no warranties with regard to such information or results obtained by its use. Fidelity disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.

Fidelity Brokerage Services, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917.

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