Think ahead about when you're likely to use the money in your IRA.

Converting your IRA can provide a benefit or a detriment depending on when you use it, so you should consider this issue before you decide to convert.

Less than Five Years

If you're under 59½ and you use your Roth less than five years after a conversion, you may pay the 10% early distribution penalty. There are exceptions for certain types of expenditures, but usually the conversion is a bad idea if you use the IRA within this time frame.

Example: You converted your traditional IRA to a Roth and took the money out two years later. You're under 59½ and you don't qualify for any exception to the early distribution penalty.

In this situation you don't have to pay tax on the conversion amount. You already paid tax on that amount when you converted the IRA. But you have to pay the 10% early distribution penalty. Chances are that you didn't really get any benefit from your conversion. You paid tax two years sooner than necessary and didn't achieve any advantage.

After Five Years, Under 59½

If you end up using your Roth IRA more than five years after the conversion but before you're 59½, you may see a benefit from the conversion.

Example: You converted to a Roth when your IRA was worth $20,000. Six years later, when the IRA was worth $25,000 and you're still under 59½, you withdrew all the money to fund a new business you were starting.

In this situation you have to pay tax and a 10% early distribution penalty on the $5,000 earnings. Yet you don't have to pay tax on the $20,000 conversion amount (you already paid tax on that amount), and you don't pay an early distribution penalty on that amount either, because it's more than five years after the conversion. The downside here is that you paid tax on the $20,000 conversion amount six years earlier, without getting the benefit of tax-free earnings because you took the money out too soon. Yet you received an offsetting benefit. Without the conversion, you would have paid an early distribution tax on the entire $20,000. You saved $2,000 by avoiding the 10% penalty tax on $20,000.

Long-Term Savings

Some people considering conversion are saving for the very long term. Perhaps you're 40 or younger, and don't expect to touch your IRA until you retire. In this situation I feel that conversion is strongly indicated if you can pay the tax without dipping into your IRA. No one can predict what our tax laws will look like 20 years from now. Yet over this long period of time, the benefits of the Roth IRA are likely to build up to a very large number.
    The same would be true of someone who is close to retirement age, but can live on other resources and doesn't expect to draw on the IRA at all.

Related

• Buy the book: Go Roth!
• IRS forms and publications: Your Work and Retirement
• Discussion forum: Retirement Savings and Benefits
• Related guide: Guide to the Roth 401k
• Up one level: Guide to Roth IRA Conversions
• Previous article: Source of Funds for Conversion Tax
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