The Investment Scientist

Roth Conversion Decision Framework

Posted on: December 19, 2010

Roth Conversion

As 2010 comes to a close, one time sensitive wealth management move affluent individuals and families should consider is converting an existing traditional IRA into a Roth IRA.

It is not a trivial decision, and there is no one-size-fits-all answer. What I hope to accomplish below is to give you a framework to help you make the best decision for you and your family.

There are two major distinctions between a Roth and a traditional IRA:

  1. With a Roth IRA, you pay tax before the money goes into the account; with a traditional IRA, you pay tax after the money is taken out of the account, or put another way, money that goes into a traditional IRA is tax deductible.
  2. With Roth, there is no minimum required distribution (MRD) in your and your spouse’ lifetimes. Only your children who will inherit your Roth IRA need to follow MRD. With a traditional IRA, there is a MRD; the goal is to force you to empty your IRA before you die.

So here is how you should make your decision:

  • If your IRA is primarily for your own retirement, the decision comes down to what you expect your tax rate will be when you retire compared to what it is now. Though it is generally accepted that tax rates will only go up, don’t forget you will earn less in retirement and hence you will be in a lower tax bracket.
  • If you plan to leave your IRA to your spouse and children, it probably makes sense to convert to a Roth, provided you have the cash to pay the tax now. The deal is good: you pay the tax now, and the money in the account will grow tax free through your lifetime, your spouse’s lifetime, and your children’s lifetime.

Once you have decided to convert your IRA, it’s better to convert in 2010 than after. Why? Now that the President and the Republican Congress have reached a compromise, the Bush tax cut will not expire for another 2 years. After that, who knows what will happen, the odds on favorite is still a tax increase given the nation’s fiscal situation.

If you convert in 2010,  you get to report your conversion in two years instead of one. For instance, if you convert $100k, you may report $50k in 2011 and another $50k in 2012, thus lessening the tax bite further.

I hope this little piece helps you make a wise wealth management decision.

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2 Responses to "Roth Conversion Decision Framework"

Good article. I added your rss adress. Thank you.

I might have done this in 2010 if I had also known that ROTH distributions are not counted towards the income that is used to reduce your social security benefits.

NONE of the conversion calculators I checked online mentioned that very important piece of information !!!!!

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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