Converting to Roth IRA?

[question everything]

On CNN, Gerri Willis (my favorite contributor) said that if anyone is in the stock market it should be to buy, not to sell. Then she said something about selling stocks at a loss for tax purposes and then added "good time to convert a traditional IRA to a Roth IRA.." or something. And I am not sure what she meant.

Anyone?

[A HERETIC I AM]

1. The IRS will allow a "conversion" of assets held in a Traditional IRA into a Roth...

but doing so causes a so called "Taxable Event".

If you have a large IRA balance it might makes sense to convert to a Roth if the projected average rate of return from now till the time you will need to access the funds will be enough to overcome the cost of the taxes that would be paid. The website www.financialcalculators.com has a calculator that can help to figure this out. Roth conversion calculator. BTW, an 8% per year average rate of return over time is reasonable with a properly allocated portfolio. This would double your money in just over 9 years. (See "Rule of 72" )

Normally if you were to take a traditional IRA and remove those funds from that umbrella before the age of 59 1/2, you would be subject to a 10% penalty PLUS the taxes. With a conversion, you are NOT subject to the penalty but are liable for the taxes. There is another restriction as well: your Adjusted Gross Income (AGI) can not be more than $100,000. If it is higher, you can not do the conversion. In 2010 that AGI limit goes away permanently (at least for now, as the rules are currently written).

The following appears on that calculator page I lnked above;

If your income is $100,000 or less and you are single or married, filing jointly, you may be eligible to convert your traditional IRAs to a Roth IRA in order to take advantage of federally tax-free earnings in the future.

You will generally pay ordinary federal income tax (but not the 10% penalty tax) on the taxable amount that is converted. Your tax-free potential is maximized if you pay the taxes from your current income or personal savings, not your IRA.*

Please note that beginning in 2010 the $100,000 adjusted gross income limit for conversions to Roth IRAs is permanently repealed. From 2010 onward, all taxpayers, regardless of income, can convert to Roth IRAs. Also, for conversions occurring in 2010, the taxpayer will only have to report one-half of taxable income in 2011 and one-half in 2012. After 2010, conversions must be reported in full in the taxable year in which they are made.

* In other words, if you have a savings account sufficient to pay the tax liability, it might make more sense to pay the taxes with that money because it will place the entire converted balance into the Roth. Clear?

Doing a conversion essentially takes a pool of money that will be taxed over time later on, as you draw it out, and tax it now, all at once. This would reduce the exposure to any income tax increases potentially imposed later on. Once taxed and the conversion is completed, the Roth can be invested almost any way you wish and any and all gains are not taxable. Just to reiterate, traditional IRA funds have not had taxes paid yet and taxes are paid as ordinary income upon distribution. Roth money has already been taxed and comes out completely tax free. I say "almost any way you wish" because many IRA Custodians (Brokerage Firms and Mutual Fund Companies) will restrict the use of Options or Margin for example, because you can not just simply add more money to the account should you have a Margin Call or if an Option trade went against you. Most firms will allow "Covered Call Writing" for instance because it is an Option Contract with very limited risk. Ask your Custodian or your Broker.

As far as the CNN contributor's reference to selling at a loss for tax purposes, it's important to remember that one can not use losses to offset gains inside an IRA. You don't have to pay Capital Gains taxes on gains inside an IRA and conversely, you can not write off losses inside one either. Those rules only apply to non tax qualified accounts, such as a regular, plain old investment account.

This strategy can indeed be worth considering if you are young enough, so that there is enough time to overcome the taxes and if the IRA balance is large enough to make sense. Use that calculator linked above and speak to a knowledgeable Tax Advisor as well as a Financial Advisor before making this move.

IRS Publication 590 discusses conversions. Scroll down to "Can you move Retirement Plan Assets".

The IRS website is actually fairly easy to navigate as their search function works really well. The thing is, reading the minutia is often as interesting as watching paint dry!

[question everything]

2. Thank you, as always, for a detailed and comprehensive explanation

I will visit these websites.

What I wonder is whether the amount that I convert - say, $50K - is taxed as an ordinary income or as capital gain. If the first, this means increasing our taxable income by $50K and, no doubt, pushing us to a higher tax rate.

If the later... I've had this IRA account for more than 20 years, most of it by now is composed of capital gain and dividends distribution. Calculating the capital gain would be a nightmare.

[A HERETIC I AM]

3. It's taxed as ordinary income.

It will be as if you got a $50,000 raise for one year only.

One of the best things about the IRA account rules is that there is NO taxation of Capital Gains, either short or long term.

For this reason, IRA's are a great vehicle in which to do "Day Trading" or make short term plays (less than 365 days and of course, as long as they're profitable!).

You are probably aware that a short term gain made in a non tax qualified account is subject to taxation at a rate of up to 35% and long term gains up to 15%. However neither of these affect IRA accounts, be they a Traditional, a Roth, a SIMPLE or a SEP/SARSEP.

The fact that the conversion will push you into a higher bracket is not unusual at all and is a major consideration when contemplating such a conversion. But as the quote I blocked above mentions, if you wait until 2010 to do this, you can stretch out the amount over 2 consecutive tax years, thus making the burden lower. Again, consult with your tax preparer so you can know exactly how much in taxes it will likely cost if you decide to go ahead with it for the 2008 or 2009 tax years.

On edit to add one more point;

One of the often overlooked advantages to the Roth IRA is that the mandatory, post 70 1/2 years of age "Required Minimum Distribution" rules of a Traditional IRA and 401(K)'s do not apply. There is no requirement to take the money out at all. Also, if you have earned income you can continue to contribute to the Roth for as long as you wish, up to the annual maximum. This can be advantageous for a person expecting a state or union pension for example or for someone that just simply wants to keep working past the age of 70 1/2.

[A HERETIC I AM]

4. An interesting article I found today about this subject;

<snip> So why would it make sense for the holder of a traditional IRA to convert funds to a Roth IRA?

First, consider the surviving spouse. A Roth IRA has no required minimum distribution (RMD) requirement. If a surviving spouse inherits the Roth account, he or she need not take any minimum withdrawals. Conversely, with a traditional IRA, a surviving spouse who takes over the IRA must begin taking taxable withdrawals from the account no later than one year after reaching age 70 ½, thereby losing out on the chance to continue to compound the account without paying taxes. Thus, use of the Roth IRA allows for an easy transition from surviving spouse to secondary beneficiaries, such as children. <snip>

This considers the Traditional to Roth conversion as part of an estate plan.

More;

http://www.lifeandhealthinsurancenews.com/cms/nulh/Weekly%20Issues/issues/2008/38/News/L38jnl-pegg