Conversion Considerations

Main considerations in deciding whether to convert a traditional IRA to a Roth IRA.

Many taxpayers have the option of converting a traditional IRA to a Roth IRA. In ideal circumstances this move can produce a huge windfall over the long run — perhaps tens of thousands of dollars in some cases. Yet for other people the Roth rollover can be a costly mistake. It's important to understand the issues before deciding whether to act. On this page we go over the main decision factors in making this choice. We also now offer an entire section of this guide dealing with this choice, beginning with The Conversion Decision.
    This page assumes you're familiar with the basic rules that apply to Roth IRA rollovers. Those rules are explained in the following pages:

• Roth IRA Rollover Eligibility
• Roth IRA Rollover Consequences
• Rollover Roth IRA Distributions

Why Roll to Roth?

You can hope to achieve several important advantages if you roll your regular IRA to a Roth IRA:

• Your Roth IRA will, in effect, be larger than your regular IRA even if it contains the same number of dollars. The reason is that the Roth IRA contains after-tax dollars. In a regular IRA, some of the earnings will eventually go to the government in the form of income tax, but in a Roth IRA you get to keep everything. A bigger IRA means bigger tax benefits. (For more on this topic, see The Roth IRA Is Bigger.)
• You can keep your money in a Roth IRA for a longer period of time. There is no requirement for minimum distributions to begin when you reach age 70½. Keeping money in an IRA for a longer period of time means extending the period of tax-free compounding.
• If you're wealthy enough have a potential estate tax liability, converting to a Roth IRA may reduce that liability. If you die holding a regular IRA, the entire IRA may be included in your estate even though part of it will end up going to the IRS as income tax when your beneficiaries take distributions. In the case of a Roth IRA, you have already paid the income tax, so your estate is smaller even though you are effectively passing the same amount of wealth to your heirs.

These benefits establish a general preference for the Roth IRA over regular IRAs. As discussed below, there may be other particular reasons to make, or not to make, a rollover to a Roth IRA. In general though, you should start with the notion that rolling your IRA to a Roth IRA is a good idea until it is proven otherwise.

If You Made Nondeductible Contributions

There's a special added benefit if you have a significant amount of basis in your regular IRA — in other words, if you made nondeductible contributions to your regular IRA. When you roll your regular IRA to a Roth IRA, the portion of the rollover that comes from nondeductible contributions is tax-free. Yet you are moving that money from a place where the earnings will be taxable to a place where the earnings will be entirely free from tax. This is a terrific bonus. You should strongly consider a rollover if you've made nondeductible contributions to your regular IRA. Note, however, that you're not permitted to roll only the tax-free portion of your regular IRA. Any distribution you take from your regular IRA, including a rollover distribution, comes partly from your nondeductible contributions and partly from other amounts (deductible contributions and earnings) that are in your IRA.

Source of Payment

An important question to ask when considering a rollover to a Roth IRA is this: where will you get the money to pay the tax? If you have the money readily available — without using any of the money that's now sitting in your IRA — you're in good shape to consider a rollover. If you have to use IRA money to pay taxes on the rollover, put on the yellow caution signal. This is a factor indicating that you shouldn't do the rollover unless you've done a thorough analysis and understand the benefits and detriments thoroughly. And if you'll pay an early distribution penalty from the money you withdraw from your IRA to pay taxes on the rollover, change the signal light to blinking red. Only in rare circumstances will it make sense to incur this penalty as part of a rollover to a Roth IRA.

Tax Brackets

Another important question to ask is how tax brackets will affect the rollover. Try to estimate what tax rate will apply to your IRA when you withdraw the money in retirement or otherwise. If you expect to pay only 15% on most or all of your IRA distributions, you should avoid paying 25% or more on your rollover unless it is strongly justified.
    If you're in the 25% tax bracket (or higher) now, and know you'll be in the 15% bracket when you retire, there's little you can do about this factor. You may want to consider preparing a detailed projection (or having a tax professional do so) to see if you can still benefit from the rollover. Unless your situation is unusual in some way, you'll probably find that there's little or no benefit in making the rollover — and the possibility of a detriment.
    Some people will find that although they're in the 15% tax bracket, the rollover will push them into that bracket for some of their income. If this is your situation, you should consider rolling part of your IRA to a Roth IRA. Perhaps you can return to this issue in a later year and roll over the rest of your IRA without getting hit with the 25% tax.
    If retirement is many years away (say, 20 or more) you may choose to make the rollover even if it appears you may be incurring more tax now than you would in retirement. Twenty years is a long time in which to enjoy the benefits of the Roth IRA. If you take full advantage of those benefits by maximizing the amount you keep invested there, your gains may outweigh the tax cost of converting to a Roth IRA. Besides, no one can predict what income levels or tax rates are going to be like 20 years from now.
    Finally, as explained above, a rollover to a Roth IRA provides a special bonus if you've made nondeductible contributions to your regular IRA. If a significant portion of your regular IRA is from nondeductible contributions you should consider a rollover even if it means paying tax at a higher rate on the portion of the rollover that's taxable. In this situation, it may be necessary to prepare an income projection (or have one prepared by a tax professional) to determine what choice works out best.

Creditor Protection

Many states provide some measure of creditor protection to regular IRAs (although they aren't necessarily completely insulated). For reasons having to do with the way state bankruptcy laws are written, there's some question whether the same protections are available to Roth IRAs. If you have a reason to be concerned about creditor protection — for example, your debts are large or you engage in a high risk business or profession — you should consider this issue before rolling a large amount from a regular IRA to a Roth IRA. And the issue is even more important if the money you're planning to roll to a Roth IRA is currently in an employer plan, protected by federal retirement law (ERISA).

A Final Caution

The discussion on this page is premised on the notion that after the rollover you'll leave your money in the Roth IRA long enough to avoid paying tax or penalties when you take your distributions. If you fail to do so, the rollover may turn sour. Before jumping on the rollover bandwagon, take a few moments (at least) to think about how and when you'll use your IRA money, and whether that use is consistent with the assumptions underlying your decision to make the rollover.