Tax-free Roth IRA conversion is a topic that can help many of you have more money for retirement … an important law change in 2010 has been a real game changer. Everyone needs to find out if a tax-free Roth IRA is right for them.

Before we get into the specifics of Roth IRA Conversion, let me tell you a story…

I live in a big city and frequently have to pay to park my car. The other day I was downtown, pulled into a parking garage, briefly read the sign which said $2.00 an hour for hours 1 through 24…I didn’t read the small print which said something about prices could be changed …I took a ticket and parked. When leaving 8 hours later I stopped at the booth and handed the attendant my ticket – she said that’ll be $42. I asked her to read the ticket again because the total should be $16 – she pointed to the fine print on the sign I had not really read and told me prices had changed since I came in … $42 was right. Fuming I paid the $42 and vowed to not make that mistake again.

A couple days later I was again downtown but this time I selected a parking lot that allowed you to pay in advance — $5 a day paid in advance. No payment when you leave. So this time, I paid in advance and just smiled when I left – there was no attendant with her hand out wanting payment.

What’s the moral of this story?

When you put your money in an IRA, 401(k), 403(b), Thrift Savings Plan or whatever “qualified” retirement account you have, no taxes are paid when the money “goes in”. How much you have to pay “going out” will depend on the tax rates in effect at that time. Just like the first parking lot.

Do you think taxes are going up? Well, I do because someone is going to have to pay for the government’s overspending and the staggering debt they’ve accumulated – and I strongly suspect it is going to be us. Now taxes can go up even though the politicians tell you they are going down! How is that possible? Fewer or lower deductions, not indexing your Social Security benefits to inflation, tying entitlement programs like Medicare to “means” testing … I could go on for a long time … but you already know the slight-of-hand practices of Washington. You know taxes are headed higher.

With a Roth IRA you pay going in and nothing coming out – just like the second garage. So if you think prices – taxes – are going to increase before you take your money out, why not pay going in? Or if you retirement account is still depressed because of stock market losses, why not buy out your partner – the IRS – while prices are low? After you convert to a Roth IRA your money no longer grows “tax-deferred”, it grows “tax-free”. And, the government can’t change the law and make your tax-free Roth IRA and the money you’ve earned on it taxable in the future because the U.S. Constitution prohibits ex-post facto laws … at least that what lawyers tell me. Of course, they could do away with the income tax…fat chance!

And, there are lots of other good benefits you’ll like about Roth IRAs … so let’s discuss the pros & cons of converting your money to a tax-free Roth IRA.

First of all, everyone is eligible to convert money to a tax-free Roth IRA – no age, income or wealth limits. The only requirement is that you must have a tax deferred retirement account to convert to a tax-free Roth IRA: traditional IRA, 401(k), 403(b), 457, TSP and any of the others.

Okay if you convert what about the taxes? Well, that’s the bummer because you have to pay them…but this is really good news rather than bad news: here’s why…:

  1. You can spread the taxes out over three years if you convert in 2010 – none have to be paid with your 2010 tax return but you’ll pay 50% with your 2011 return and the other 50% when you file your 2012 taxes in calendar year 2013.
  2. You can pay the taxes with other money and in effect change taxable money into tax-free money. Let me give you an example: Let say you have $100,000 in a regular IRA and are in the 25% tax bracket – this makes the arithmetic easy. Since you’re in the 25% tax bracket, you only own $75,000 of the $100,000 IRA – the other $25,000 belong to your good Uncle Sam who lives in Washington DC. If you convert all the $100,000 to a Roth IRA and pay the taxes from other money like from a bank CD, you will have $100,000 growing tax-free and you’ll own it all. So you’ve really converted $25,000 from the “taxable” category to the “tax-free” category – and that is a powerful advantage, especially if taxes rise and really an advantage if it will be along time before the money is withdrawn from the Roth IRA.

Of course, you don’t have to convert all your money – you can just convert some of it. And, you might want to do this so you can stay in a lower tax bracket. You might want to convert some this year, more next year and so on. I suggest you visit with your financial advisor about whether or not a Roth IRA conversion would be good for you and if so how much and when should you convert.

Once converted to a tax-free Roth IRA, you do not have to withdraw it unless you want to. Many of you probably have to take Required Withdrawals from your qualified retirement accounts now even though you don’t need the money and would prefer to leave it in your tax-deferred retirement account. The reason for the mandatory withdrawals is because the tax-man – the IRS – wants his share when you reach 70½. He really don’t care that you would prefer not to take it and don’t need the money for retirement. But, if your money is in a Roth IRA you don’t have to withdraw it unless you want to – and that’s a big advantage because you can enjoy the tax-free growth for the rest of your life, and as we’ll see in a moment your kids and grandkids can also enjoy tax-free income.

What happens if you die before using your Roth IRA money? Bad news for you but more good news for the money you left behind – it can be transferred to your surviving spouse tax-free and he or she can withdraw it – principal and earnings – tax-free. No taxes will be paid by your surviving spouse. But, it gets even better. You or your surviving spouse can even leave it to your loved ones – children, grandchildren, nieces, nephews, or anyone you choose – and they get to withdraw it tax-free too – both the amount you left them and any earning it makes. Now, non-spouse beneficiaries have to start withdrawing a minimum amount each year…but they can spread the tax-free withdrawals out over their lifetime. They will pay nothing when leaving the tax garage – and they may not be leaving for decades. I don’t know about you, but I like the idea of leaving my family tax-free money that grows tax-free until they actually use it. Of course, you can make arrangements to control how the money is paid out after you depart – nothing very complicated … your financial advisor or lawyer can give you the details.

You can change your mind and undo your tax-free Roth IRA conversion – you have until October 15th of the following year. Why October 15? This is the last date you can file your income taxes for the previous year. Why might you change your mind? Let’s say you have your money in mutual funds and on the day of the conversion they were worth $100,000 – you’d pay taxes on the $100,000 because that is the “fair market value”. So you convert the $100,000 and time ticks forward … and six month after conversion the market sinks like a rock — your mutual funds are now only worth $50,000. Can this happen? Yes it can…in fact it has happened twice since 2000 – remember the dot.com bust? The stock market as measured by the Dow Jones Industrial Average – a broad measure of market value – dropped by over 50% over 2000-02 — and the same thing happened again between October 2007 and March 2009…this time the culprit was the Great Recession. So it can happen and if it does, you’ll want to change your mind and undo the Roth conversion so that you only have to pay taxes on $50,000 instead of a $100,000. Think about this “loophole” – if taxes go against you, you can change your mind but if they go your way you can stay put. Nice!

You don’t have to move your money or select another investment when you convert to a tax-free Roth IRA … but conversion is usually a great time to review your investments with your financial advisor to make sure they are still suitable for you and your family.

Of course you can’t convert to a tax-free Roth IRA if your money is still locked up in a 401(k) or another employer-sponsored retirement plan. But, there are ways to free up all or some of this money while still working and regardless of your age. Again, your financial advisor – if they’re on the top of their game – can help you by telling you about in-service, non-hardship provisions that can be easily added to most 401(k) plans.

I’ve covered a lot of territory about tax-free Roth IRA conversion in a short time. So let me leave you with two main points:

  1. Everyone need to find out if a tax-free Roth IRA conversion is suitable for them and if so how much, when and what investments;
  2. You should never attempt to convert your retirement money to a tax-free Roth IRA without professional help.

So, what should you do? Talk to your financial advisor and find out if a tax-free Roth IRA will help you have more money in retirement. The biggest fear of retirees is running out of money – and using the tax-free Roth IRA conversion just might be a great way to insure this doesn’t happen to you.

Shelby J. Smith, Ph.D.
February 24, 2010

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