Thanks to new rules that went into effect in January, for the first time ever, every American with an IRA can qualify for conversion to a Roth IRA, creating the opportunity for tax-free growth of their retirement investment dollars. But converting a traditional IRA to a Roth is considered a taxable event, which means you'll owe taxes on the money that is converted, less any nondeductible contributions made to the traditional IRA.
If you're considering converting IRA assets to a Roth, first determine how you'll pay the associated taxes.
Part of the good news about Roth conversion is that the new 2010 rules include an option to spread the taxes out over two years, paying half each year. "If you convert in 2010, you'll have until tax year 2012 to pay all the taxes, which means you won't have to finish paying them until April 2013," says Greg McBride, senior financial analyst at Bankrate.com. "If you make the conversion in January 2010, you'll have 27 months to pay the first half and 39 months to pay the second half." While the new Roth eligibility rules are permanent, 2010 is the only year when taxes can be paid in two subsequent tax years; after 2010, all taxes will be due during the tax year in which the conversion takes place.
Keep in mind, though, that if you decide to split your tax payments, it will add to your income in those tax years. "Make sure you adjust your withholding to account for that accompanying added tax liability. Or you can make estimated tax payments in 2011 and 2012 so that you won't incur any underpayment penalties," says Kay Bell, Bankrate's contributing tax editor and author of "The Truth About Paying Fewer Taxes."
Another thing to keep in mind: On Jan. 1, 2011, the tax cuts of the Bush administration are set to expire. That means that unless Congress acts, the 10 percent rate will also disappear and the top rate will go to 39.6 percent. "While lawmakers likely will keep the lowest 10 percent tax bracket, President Obama has indicated that he will let the rate rise for higher income earners," says Bell. "If you are likely to be in that tax bracket, you might want to reconsider deferring your IRS conversion taxes."
You don't have to defer taxes -- you can pay all the taxes in 2010 if you wish. Ask your tax adviser to run the numbers to see which way will cost you less taxes.
Where will you find the funds to pay the taxes associated with converting to a Roth? Consider these three options.
Pay taxes with the IRA's assets
Some IRA owners simply use assets from the IRA to pay the taxes on the conversion. This may be the only option if you have no other resources, but a large deduction can also severely set back your IRA's potential growth." Using the IRA to pay the taxes defeats the purpose of conversion," McBride says. "The whole idea of converting to a Roth is to turbocharge your future returns because you don't have to worry about taxes."
Most financial experts advise against using assets from the IRA to pay the taxes, as it can take years to replenish those funds. "Depending on your age, it would be unlikely that you or your heirs would recoup assets from the IRA if you use them to pay the taxes," says Marcia Mantell, owner of Mantell Retirement Consulting in Needham, Mass. "If you are under age 59½, you'll lose another 10 percent of the IRA money (that portion used for taxes) to an early withdrawal penalty. While that doesn't sound like much, it is a significant amount to have to rebuild in your account."
Use other assets
By turning to other liquid assets to fund the tax bill for your Roth conversion, you'll keep your Roth IRA robust, with potential for greater growth. Mantell cautions against tapping into funds set aside for other financial goals, or if you need your assets to help you get out of debt before retiring.
The best options are accumulated cash savings such as funds held in a savings account or CD. Another alternative is to sell securities held in a brokerage account to pay the taxes, although those sales are considered taxable events and may add to your tax bill. Avoid that problem by selling "a loser investment" so the loss can be offset against your income, Bankrate's McBride says. Or sell a winner "if your gains would be balanced by losses on other securities," says Stephen Mitchell, a consultant and chief operating officer of the Retirement Income Industry Association.
Just don't forget to consider the consequences. Depending on which assets you use to pay the taxes, "you may need to rebalance those other investments to get you back to your investment strategy, which could incur an additional tax bill," Mitchell says. "For instance, if you use your emergency fund to pay the taxes, you will probably want to replenish that emergency fund and you may have to liquidate other assets to do that," which could result in a taxable event.If coming up with cash to pay taxes on your entire IRA isn't feasible, consider converting a portion of the account rather than the whole thing. "It's not an all-or-nothing proposition," Mitchell says.
Use life insurance proceeds
For some families, a good strategy may be to simply purchase life insurance now, says Dave Freitag, marketing officer for Impact Technologies, a software manufacturer for the financial services industry that has just released a new suite of Roth IRA conversion analysis tools. Upon the death of the IRA owner, the spouse or dependent can convert the IRA to a Roth, use the life insurance to pay the taxes, and receive tax-free payments throughout retirement or stretch the tax-deferred dollars over multiple generations.
This strategy would only work for investors who want to leave the money in their IRAs to their beneficiaries, rather than use it for their own retirement. In that situation, "the life insurance simply creates the cash needed to fund the expense of the (Roth) conversion," Freitag says. "Frequently, liquid funds are not available to the surviving spouse to make this type of tax payment. The insurance money shows up at just the right time."