As the old saying goes, there are only two certainties in life: death and taxes. And if you’re  thinking about converting your traditional IRA, like a 401k, to a Roth and you’re asking, “Do I have to pay taxes?” the answer – unfortunately – is yes.

My husband and I have been debating the pros and cons of a traditional IRA to Roth conversion for the past several months. Although I didn’t make the mistake of leaving my 401k behind when I left my full-time job back in late 2010, I did fail to do enough research before rolling over my retirement account. Although 2011 was a turbulent year for investors, the Dow did gain about five percent; meanwhile, my IRA lost three percent. Needless to say, I’m not happy with this investment and am looking to do better in 2012.

Why A Roth?

That’s where the conversion to a Roth IRA comes in. My husband’s employer offers both traditional and Roth options; he elected to go with the Roth. Right now, we’re in the 15 percent tax bracket. Given the political climate and our own future earnings, we expect to be in a higher tax bracket – via upward mobility, political wrangling, or both – by the time we retire. That’s why the Roth’s “pay taxes now, withdraw tax free later” plan was attractive to us.

The Rules of Conversion

Right now, my traditional IRA with my current broker has just shy of $25,000 in it. It’s not a lot, but it’s not bad for someone who is (A) seven weeks shy of turning 30 and (B) didn’t really start investing in earnest until the birth of her first daughter, which ironically happened the day Lehman Brother filed for Chapter 11 bankruptcy.

If I want to roll that $25,000 from my traditional IRA into my husband’s Roth – which has performed better than the market average over the past two years –  I first have to make some decisions. First of all, I need to decide how much of that $25,000 to roll over. While I could roll the entire amount into the Roth, I’d then be responsible for paying taxes on that entire amount (more on the tax implications of a conversion in a moment). However, if I chose only a partial conversion, I could limit my tax burden while maximizing the diversification of my investments.

Tax Implications

The dark side of rolling over from a tax-deferred account like a traditional IRA to a tax-free account like a Roth is that darned tax bill. Because the $25,000 in my IRA would have to be reported on my taxes (either my 2011 taxes, if I made the switch by April 17th, or my 2012 returns if I waited until after that date), it would mean several things:

  • My taxable earnings would be bumped up $25,000
  • As a result of $25,000 more in reportable income, it would bump me up from the 15 percent tax bracket to the 25 percent bracket
  • In my situation, the jump to the higher tax bracket would mean the difference between a tax refund and a tax bill – I’d either have to take money out of my emergency fund to pay the difference, or I could elect to withdraw the money from my IRA… with a 10 percent early withdraw penalty, since I haven’t reached 59 1/2
  • I’d likely pay around $5,000 in taxes on the conversion alone
  • In the future, my Roth contributions would not be deductible like my traditional IRA contributions were, giving me more taxable income and a higher tax burden

In previous years, the government has given individuals who converted traditional IRAs to Roths the option to spread out the tax burden over multiple years, decreasing the likelihood that the conversion would bump you up to a higher tax bracket. The 2011 tax year, however, is the last year tax payers will have that option.

To Convert Or Not To Convert?

Yes, that is the question. I decided to use the retirement Roth IRA worksheet at Smart Money to see if a conversion makes sense for my future finances:

  • Current value of my traditional IRA: $24,878.13
  • Taxable portion: 100%
  • Years til retirement: 35
  • Current tax rate: 15%
  • Estimated retirement tax rate: 25%
  • Estimated return: 8%

The results were astoundingly in favor of converting to a Roth. The calculator estimated that with an eight percent return over the next 35 years, my traditional IRA would be worth just over $275,000 when I retire. Not bad. But if I converted it to a Roth, the account would be worth $367,000 – 33 percent more than the traditional account. The winner? A clear victory in favor of converting.

Moving At Warp Speed

Since the ability to split the tax burden incurred by converting to a Roth won’t be extended for the 2012 tax year, I decided that time was, literally, money in this case. By splitting up the extra income incurred by the conversion over two years, I’ll avoid jumping into the higher tax bracket – plus, I’ll get to split up the tax bill as well into something more doable for my family’s budget. I’m not looking forward to owing Uncle Sam on my taxes for the first time in my adult life, but I know the additional earnings to my Roth will pay off in the long run.


Libby Balke

Libby Balke