Tax Tips
Is it Time to Switch to a Roth IRA? - February 2003
Richard Scrivanich - Partner
When Congress created Roth IRAs in 1997, it also set up a way for taxpayers to convert a traditional IRA to a Roth IRA, for those individuals who preferred the tax treatment of a Roth. Although the rules pertaining to conversions have changed very little since 1997, the generally lower value of investments in 2003 might make this a good time to consider the switch from a regular IRA to a Roth, even if it was not worthwhile in the past.
WHAT ARE THE DIFFERENCES BETWEEN A REGULAR IRA AND A ROTH IRA?
There are differences in both the deductibility of contributions and the tax treatment of withdrawals. For a regular IRA, contributions may be tax-deductible, depending on the level of your adjusted gross income (AGI) and whether you are a participant in the retirement plan sponsored by an employer. Roth IRA contributions are not tax-deductible under any circumstances.
Distributions from a regular IRA are taxed to the extent they represent either earnings or pretax contributions (i.e., contributions that were deducted on your return when made). Distributions from a Roth IRA-if they have been in the account for at least five years-are generally tax-free if the withdrawal occurs after you reach age 59 ½, die, or become disabled.
Thus, one of the major advantages of a Roth over a regular IRA is that earnings within a regular IRA are tax deferred, while earnings within a Roth may escape taxation permanently.
THE TAX TREATMENT OF A CONVERSION TO A ROTH IRA
In general, you're taxed as if you withdrew the total in your IRA in the year of the conversion. This means paying taxes at ordinary income rates on the total IRA balance, less any contributions that were not deductible when made.
Not everyone is eligible to make a conversion. A conversion can be made only if a taxpayer's modified AGI for the year of conversion is $100,000 or less. This limit applies to both single and married taxpayers. Also, married individuals must file a joint return for the conversion year.
THIS YEAR MAY BE A GOOD TIME TO MAKE THE SWITCH
If a conversion makes sense, 2003 may be a good year to make the switch. First, because of the unpredictable economy this year, many taxpayers may find themselves under the $100,000 ceiling. Second, because of generally depressed investment values, the value of your IRA may be showing a significant dip at the current time. Because the tax on the conversion is based on the value of the IRA at the time of the conversion, you will pay less tax than if you had switched in the past.
SOME TAXPAYERS MAY NOT WANT TO CONVERT
Not everyone will benefit from a conversion, even if they are eligible. For instance, if you expect your tax bracket to be lower after retirement, you may do better by keeping your funds in a traditional IRA. You will also want to keep in mind that your increased AGI in the year of conversion may make you ineligible for certain tax deductions or credits that have a limitation or phase-out based on AGI, such as the child tax credit or education credits. Other items may be affected as well, such as the $25,000 rental exception to the passive loss rules, the personal exemption and the phase-out of itemized deductions.
Estate tax planning may also affect your decision. While both traditional and Roth IRAs may be subject to the federal estate tax, the income tax treatment by beneficiaries differs, and should be taken into account when deciding whether to make the switch.
WHAT'S THE BOTTOM LINE?
The only way to decide whether it makes sense for you to convert your IRA to a Roth is to run the numbers, taking into account your own unique tax situation, your financial goals for retirement, and your projected financial picture for the years to come. We would be happy to help you with this analysis to determine whether a conversion is right for you and whether 2003 is the year to take action. As a result of the lower investment values so far this year, a Roth conversion may be yet another opportunity to turn a financial negative into a positive before year end.
If you have any questions about this article, or any other tax matter, please feel free to give me a call at (562) 698-9891.
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