Converting to a ROTH IRA

Factual Questions
1

I have some investments in an IRA that was originally a 401K. One of these investments is a stock that had been stagnant but some people believe will blow the roof off very soon. These people tell me to convert the portion of the IRA to a Roth IRA.

What are the advantages/disadvantages?

I’m 35 the amount in question is around 12K and I make between 40 and 45K a year

2

The disadvantage is that you’ll pay tax on the conversion as if it is income. $12k taxed at a 15% bracket would be $1800 in tax. But it’s hard to tell all the implication it will have because the increase in net income can sometimes cost you tax credits. In 2010 only, you get an added incentive - the option to include half the income over two years of tax returns rather than all in one year.

Once you make the conversion, you have to leave it in the Roth for at least 5 years; taking it out of the Roth in that time period will trigger a 10% withdrawal penalty. This is the same withdrawal penalty you’d normally have with your current IRA.

The advantage is that (after the five years) you can take distributions from the Roth IRA tax-free. In the case of stock that might go up quickly, you can see the advantage: perhaps it is better to pay tax now on $12k instead of later on $30k (or whatever it grows to).

Ultimately, you should talk to a tax pro and financial planner, since they can help you put specific numbers on it and advise you regarding how it fits your overall investment/retirement strategy.

3

I’m in the same boat with much of my savings in pre-Roth retirement accounts. For me, it’s a tougher call because I’m 60 years of age. At 35, however, I wouldn’t think twice about converting. To have 30 years or more at tax free growth is the best thing since sliced bread. The tax you’d pay now for conversion would be relatively insignificant considering the future benefit.

4

I’m 60 too, and have decided that it does not make sense for me to convert.

However, for those younger than I, you should look hard at a conversion this year. As noted above, you will be able to spread the taxable dollars you convert over two years - and unlike previous years, there is no limit on your income. Used to be that you could not convert if you made more than some amount. So, this is a GREAT year to convert if you can.

This calculator should help you :

https://calcsuite.fidelity.com/rothconveval/app/launchPage.htm

5

Thanks for the info. So if I convert now I would pay 900 in taxes in 2010 and 900 in 2011

6

Actually, it’s even better than that. A 2010 conversion can be split between tax years 2011 and 2012, which means paying the tax in 2012 and 2013.*

However, the tax due gets calculated based on the $12,000 conversion amount. So $6,000 would be added to the taxable income for 2011 and 2012. $900 in tax is a good estimate assuming a 15% tax bracket, but it’s possible that credits, deductions, etc. could put you in a 10% bracket or even eliminate the tax due. It’s also possible you could win the lottery or get a huge raise and pay at a 25% tax bracket, which would make the tax $1500 each year. (And, it’s also possible that Congress hikes the tax rates, so you never know.)

I try to avoid giving specific advice without knowing the details of a person’s situation and goals, but this really is a huge opportunity.

  • Note: you do have the option to pay tax on it all in 2010 instead of deferring to 2011/12. For people with business losses, unemployment, etc. that might be preferable. I did my Roth conversion in 2009 precisely because I knew I’d pay a lot less tax on it this year than in any of the next three years.
7

I think I have a good grasp on this. Let me just make sure I understand this

If in the morning I call my IRA company and ask them to I can convert part of my IRA which was a 401K originally to a Roth IRA and pay the tax on the 12K over two years.

If before I make the change the good things happen then I would have to pay the tax on the new value or keep it as it is.

I know for certain that I will not get a huge raise as I’m a state employee and they are talking about freezing our wages and increasing what we contribute to our health plan.

8

Do the Roth IRA contribution limits not apply to rollovers from 401Ks?

I thought there was an annual $5000 limit?

9

That’s right. The tax paid will be based on the current value of the assets rolled over.

10

The contribution limits of $5,000 are only for new contributions, not conversions (which are equivalent to a rollover). There is no limit to conversions except that a very large Roth conversion all at once would hit you with a mountain of tax.

You should be able to rollover a 401k into a Roth IRA, but you’d want to talk to the company that manages the 401k. I don’t think rollovers are permitted until you leave the job where the 401k started.