Does it make sense to (and what are the tax implications) of converting IRA funds into a Roth IRA account?

January 25, 2007 10:46 AM

Does it make sense to (and what are the tax implications) of converting IRA funds into a Roth IRA account?

I have heard that some financial advisers recommend Roth IRAs over traditional IRAs. I am a student and therefore my income is extremely low. A friend said that if I want to do an IRA to Roth IRA conversion, now would be the time as the taxes I would owe will be less than if I had a higher income since I'm now in a lower tax bracket.

My questions are:

1. What are the benefits of having a Roth IRA over a traditional IRA?
2. Will these benefits still hold true if in some time in the future I borrow from my retirement funds to purchase my first home (I have no plans to do this anytime soon).
3. How can I determine how much I will owe in taxes for the conversion?
4. Is there anything else I need to know?

posted by mintchip to work & money (12 comments total)

I am not a CPA, the following is what I learned when I looked into this:

You will have to pay the amount in taxes that you would have had to pay on the money that went into the traditional IRA. If contributing to the traditional IRA moved you into a lower tax bracket, I don't know if you'll owe even more to compensate for that. Converting doesn't make a whole lot of sense for me - By the time you start pulling money out of the IRA, you'll be on a fixed income anyway so your taxes should be low then as well. You'll also see less growth on the money, as the amount in the Roth will start lower than the amount in the traditional IRA. It still may be worth it to you if you can convert without much of a hit.
posted by mzurer at 10:54 AM on January 25, 2007

My guess is, even on a fixed income, you'll be taxed at a higher rate than you are now. I would convert. The Roth "locks in" your retirement account because it is no longer subject to changing tax rates. If you hit the lottery after you retire, the traditional IRA will lose value do to higher taxes - that can't happen with the Roth.
posted by taliaferro at 11:10 AM on January 25, 2007

because it is no longer subject to changing tax rates. If you hit the lottery after you retire, the traditional IRA will lose value do to higher taxes - that can't happen with the Roth.

This doesn't have anything to do with changing tax rates or moving up in income tax brackets though -- it's just that Roth IRAs aren't taxed when you withdraw your funds, as long as you cash it in when you retire (See below). Traditional IRAs are. So, to answer a couple of your questions:

1. If you're young, a Roth is a good idea because it doesn't ever get taxed, so your money will sit in there for a looooooong time making compound interest.

2. As far as I know, you can remove your principal from a Roth any time you want; it's removing the interest that you've made that'll do bad things.

3. I don't know how to calculate the taxes on it, but figure that you're basically going to be paying income taxes on the whole thing, since this is money you set aside from being counted on your tax return, and you've made interest on it. Plus, you'll be substantially penalized for withdrawing your money prior to retirement age.

So, I'd seriously have to ask why you don't just start a new Roth IRA and leave the old IRA as it is? You can have more than one IRA account, just don't contribute to the old one. In that respect, no, it doesn't make sense to convert a traditional IRA to a Roth at all, but at your age, it does make sense to be investing in a Roth.
posted by LionIndex at 11:24 AM on January 25, 2007

Amend my anwer #1 to read "tax-free compound interest".
posted by LionIndex at 11:25 AM on January 25, 2007

Rolling into a Roth means that, in the year that you do the rollover, the amount of funds moved from traditional to Roth IRA is counted in your adjusted gross income. If, after this process, your AGI is still so low that you don't owe any more taxes than you otherwise would have, this is a no-brainer: you absolutely should do it.

You should probably do it now anyway if you can. I regret extremely leaving anything at all in my Traditional IRA; there were a number of years where I wasn't making any income and I should have moved it all into the Roth then.
posted by ikkyu2 at 11:44 AM on January 25, 2007

If, after this process, your AGI is still so low that you don't owe any more taxes than you otherwise would have, this is a no-brainer:

How can I figure out if I wouldn't owe any more taxes than I otherwise would have? Is there an AGI cutoff point? I don't know too much about taxes.
posted by mintchip at 12:08 PM on January 25, 2007

why you don't just start a new Roth IRA and leave the old IRA as it is?

One reason to consolidate would be that it would be one less "custodial fee" that you'd have to pay.
posted by Alt F4 at 12:10 PM on January 25, 2007

How can I figure out if I wouldn't owe any more taxes than I otherwise would have? Is there an AGI cutoff point? I don't know too much about taxes.

There's a table in the back of the tax instruction booklet. It tells you how much you owe fore a range of incomes.

When you're doing your taxes, check to see how much tax you owe with and without the IRA stuff added into your AGI.
posted by willnot at 1:29 PM on January 25, 2007

I did this calculation (a while ago) using several different parameters, and learned that - you come out exactly even over the life of the account, if you have to use the IRA proceeds to pay the taxes. You come out ahead with the conversion if you use other resources to pay the taxes.

My suggestion would be to start up a new Roth as well as continuing to fund the IRA. And, of course, make maximum contributions to each.

(Hey, grandparents. If you are thinking of up-to-$12k gifts for grandkids as an estate planning technique, and if the kids have earned income: put $2K of it in an IRA for them, instead of a regular account. They'll get a bit of a tax break, and they may even leave it in the account, if they're smart. Put some of the rest into a Roth account.)
posted by megatherium at 6:30 PM on January 25, 2007

mintchip: How can I figure out if I wouldn't owe any more taxes than I otherwise would have?

You should hit up the very easy-to-use IRS site and take a stab at calculating your own taxes for this year. The first two things to download are form 1040 and the instructions for form 1040, which is called 1040i.

Follow the instructions. Print 'em out if it's easier. Work in pencil. It takes a few hours. If you don't have the exact numbers in front of you, guess. You'll come up with an approximate answer.

Or you could ask an accountant. But if you wanted to do that in the first place, why come here? In general the tax forms are designed so that people of average intelligence can work them.
posted by ikkyu2 at 7:25 PM on January 25, 2007

It doesn't sound like this applies to you, but I'll mention it for anyone else reading the thread: If you have multiple IRAs, you don't need to convert them all to Roth IRAs in one year. Instead, you can convert them one at a time over a number of years to spread out the short-term pain, if you like. (I don't believe you can do this with fractions of a single IRA, however.)
posted by pmurray63 at 9:34 PM on January 25, 2007

I don't believe you can do this with fractions of a single IRA, however.

Not true. You can convert as much or as little each year of an IRA as you like in order to optimize your tax situation. You can also change your mind up until the time that you file your tax return and recharacterize (revert back to the original IRA) any fraction of that fraction.
posted by JackFlash at 11:14 PM on January 25, 2007