Roth Conversion


Recently, you’ve probably heard the resurfacing of the old joke:  “my 401k has turned into a 201k.”  Those who have stock positions in their traditional IRA’s and retirement plans have watched in dismay as their portfolios have significantly diminished in value.  But with nearly every crisis comes an opportunity, and for those in the right situation this idea may be worth considering.

Retirement account owners who have less than $100,000 in adjusted gross income may be able to convert their now lower balance accounts into a Roth IRA.  This option becomes attractive for those who believe that the underlying positions in their account will eventually recover in value.  The benefit of having appreciating assets in a Roth IRA is that any gains (taken after five years and age 59 ½) are tax free. 

Of course taxes must be paid on the amount converted.  But lets say ‘Johnny’ has a traditional IRA invested in stocks, that was worth $75,000 at its peak.  Today, that account may only be worth $35,000.  If he decides to convert the account to a Roth IRA, he must pay tax on the current value of $35,000.  But, if the account grows back to the $75,000 or even higher, the entire balance is now free from income taxation.  And the possibility of higher future tax rates, make the Roth look even more attractive.

If you are not able, or don’t want to pay the taxes on an entire conversion, you may want to consider converting only a portion of the IRA to a Roth, selecting those beaten down positions which you believe are more likely to recover.  If your income will be over $100,000 for the year 2009, a Roth conversion is not an option.  However, under current law, that limitation will be repealed in 2010 making a Roth conversion available to everyone.  Another advantage of converting in 2010 is that the tax liability can be spread over the tax years for 2011 and 2012.

So what happens if you convert to a Roth and instead of going up, the assets continue to decline in value?  Currently provisions allow for the Roth to be re-characterized by a certain date back to an IRA and thus avoid the taxes due on the conversion. 

The decision to convert can be complex and doing a conversion to a Roth is usually not a good idea if you don’t have the ability to pay the taxes due using money outside the IRA.  There are other reasons why a Roth conversion is not a good idea for everyone.  Since everyone’s situation is different, you should consult with a CPA or qualified tax advisor before deciding to convert your IRA to a Roth.

Written By Kimber Heaton CFP