Should I convert a large balance to a Roth IRA?

The BIG Roth Conversion: If you have a large balance, with a large potential tax bill upon conversion, should you convert to a Roth?

Use the calculator at Roth Conversion Calculator to help you with your conversion:
Roth IRA Conversion with Distributions

For the most part the decision boils down to how much you will pay in taxes and when. If you expect your income tax rate to increase – convert to a Roth. If you expect your income tax rate to decrease, stick to a traditional IRA or retirement plan. But if you are one of the lucky few with a really big conversion to think about, this gets a bit more complicated.

For example:

My friend has a big conversion (some would say huge). He is at or near retirement, currently in the highest tax bracket (35%) and fully expects to remain at the top bracket for his entire lifetime. He also believes that rates will increase to 39.6% in 2011, if not higher. He has more than enough cash to pay any tax bill created by the conversion without using any of the account balance.

This is probably a great opportunity to convert. Probably the clearest example I could imagine. But there is still risk involved, but overall a very clear conversion opportunity.

Now consider the same person, but instead of being in the highest tax bracket of 35%, his marginal tax rate is 25%. And he expects his marginal income tax rate to be about the same at retirement. The problem? If you convert a large balance of say $500,000 to a Roth, the marginal rate of return would be an average of about 33%, assuming 2010 marginal tax rates. So your Roth Conversion taxes would be 33% and your retirement tax rate would be 25%. This is an 8% tax hurdle you would need to overcome.

Is possible to overcome this? Yes – if you have a longer time horizon vs. being currently retired and if you lengthen your time horizon by planning for your Roth IRA being passed on to your beneficiaries instead of using it in your retirement.

More Roth Conversion factors to consider

I consider a BIG conversion one that will cost you $100,000 or more in taxes (yes, your tax bill, not your conversion amount), and most likely puts you in the highest tax bracket for at least part of the conversion. For some, the big conversion will be an easy choice. Others may have more ambiguity. Here is what you need to find out:

1. What is your real marginal tax rate for the conversion? Since conversions of this size often span more than one tax bracket, you need to know the real marginal tax rate for the increase in taxable income. Using your tax bracket alone will under-estimate your tax liability. The Roth Conversion calculator will automatically calculate your marginal tax rate for your conversion amount, accounting for a possible span over multiple income tax brackets.

2. Where will you get the money to pay the tax bill? Most likely, it's a horrible idea to use the Account balance that is being converted to pay your taxes. All distributions will be taxed and if you are under 59 ½ you will be subject to a 10% penalty on top of that. But, if you don't have the outside money to “spend” on this, run the numbers. Especially if you are already retired and subject to a RMD you don't need.

3. What do you think your future tax rate will really be? Since your future tax returns probably won't have this huge lump sum caused by the conversion thrown in the mix, only those who would be in the highest tax rates without the conversion can easily answer this one. You can use the calculator at: http://www.dinkytown.net/java/TaxMargin.html to see your current marginal tax rate for little guidance. If the conversion moves you up a tax bracket or two, this can dramatically impact the effect of converting. Since you will NEVER be able to predict your exact future tax rate, make sure to run scenarios with a low, middle and then high tax rate.

4. Do you need the money? This may seem silly, but it's important. Do you need this money for yourself? If you are going to use up the IRA for your own expenses and retirement don't count on any advantage from stretching out distributions to beneficiaries (like your spouse or children). Look only at the impact of the conversion in your expected lifetime. Run the scenarios above, but don't include any beneficiaries. If you plan on just letting this account build up and then giving it to your kids – then seeing the impact of Stretching out your distributions is extremely useful.

Use the calculator at Roth Conversion Calculator:

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Even more Roth Conversion factors to consider:

Should I delay my tax bill to 2011 and 2012? Unless you are in the highest bracket (35%) this is probably a good option. Run your analysis both ways to make sure, but unless your tax rate goes up in 2011 and 2012, delaying works for you. The exception is if you know you will be in the top tax bracket for 2010, 2011 and 2012. Currently the top tax bracket is scheduled to rise to 39.6% in 2011. In this situation, paying your entire bill in 2010 might work to your advantage.

Should I convert only part? If it's a good idea to convert some, in this situation it's probably a good idea to convert all of it. But – make sure you can afford the tax payment. If you can't, or it's just too much of a stretch, maybe a partial conversion is a good option.

Try to run through multiple scenarios for the factors that affect your situation. Splitting your tax bill or not is pretty easy to test out. Predicting your future tax rate? This is a bit more difficult. Now try it all again with only half of your balances. One point of all of this I want to make clear: The harder something is to predict, the wider range of potential outcomes you need to plan for. Run your scenarios, compare the results and decide for yourself: Should I Convert to Roth?

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