If you are eligible to convert a regular IRA to a Roth, chances are you should do it, and you should do it quickly!
If a single taxpayer (or married couple) has Adjusted Gross Income ("AGI") of $100,000 or less, a regular IRA can be converted to a Roth. The regular IRA will be taxed currently (no 10 percent penalty for being under age 59-1/2). If you convert before December 31, 1998, you may report the taxable amount evenly over the next 4 years. A conversion after 1998 requires payment of the total tax in full.
The major Roth differences are:
With creative tax planning, it may be possible to keep AGI below $100,000. In some cases, such as a partner in a partnership or a shareholder of an S Corporation, it may not be possible to control AGI. In other cases, however, limiting AGI for the remainder of the year may be possible. Business owners and employees might elect to defer large year end bonuses until the following year. An investor might arrange dividends and capital gains to avoid additional income for the year. There are tax issues to deal with, but the reduction in AGI can often be accomplished. (If it is too late for 1998, consider these techniques for 1999.) An example:
Even if an IRA is currently small, it will be much larger in the future. Reporting a small IRA as income over the next four years may be painless, but will allow the larger Roth to be entirely income tax free 20-30-40 years from now. A conversion should be almost automatic for younger individuals and individuals in lower tax brackets who expect to be in higher brackets in later years.
"Manufacture" an IRA
What if your AGI will be below $100,000 but you don't currently have an IRA? Many individuals participate in a company qualified profit-sharing plan. The profit-sharing plan could be amended to allow a distribution to individuals who have participated for at least 5 years, even if they are actively employed. The employee could then "rollover" to a regular IRA, which would be immediately converted to a Roth. The profit-sharing benefit would be reported as income, and taxes would be paid (but without a 10 percent penalty). The employee would continue to participate in the company's profit-sharing plan as well.
Important Considerations
To get the full advantage of a conversion, two aspects are critical:
If a single taxpayer (or married couple) has Adjusted Gross Income ("AGI") of $100,000 or less, a regular IRA can be converted to a Roth. The regular IRA will be taxed currently (no 10 percent penalty for being under age 59-1/2). If you convert before December 31, 1998, you may report the taxable amount evenly over the next 4 years. A conversion after 1998 requires payment of the total tax in full.
The major Roth differences are:
- All distributions are income tax free.
- Distributions may usually be taken at any age without penalty.
- There is no requirement distributions begin at age 70-1/2.
- The Roth owner may choose to take no distributions and leave the tax free benefit for children or grandchildren.
- Projected AGI is above $100,000.
- Too much bother because existing IRA is too small.
- Don't have an IRA.
With creative tax planning, it may be possible to keep AGI below $100,000. In some cases, such as a partner in a partnership or a shareholder of an S Corporation, it may not be possible to control AGI. In other cases, however, limiting AGI for the remainder of the year may be possible. Business owners and employees might elect to defer large year end bonuses until the following year. An investor might arrange dividends and capital gains to avoid additional income for the year. There are tax issues to deal with, but the reduction in AGI can often be accomplished. (If it is too late for 1998, consider these techniques for 1999.) An example:
An executive age 55 has a $600,000 rollover IRA from a previous employer's retirement plan. He has elected to defer receipt of a year end bonus to keep his AGI under $100,000 for 1998. His IRA will be included as income at the rate of $150,000 for each of the next four years. He has arranged a line of credit to help finance the payment of taxes when due. In 15 years, at 9 percent interest, the Roth will be about $2.2 million. He can take distributions from the Roth whenever he wants, or take none at all. All payments from the Roth will be income tax free. The original IRA would also have been worth $2.2 million at age 70. However, he would be required to start payments at age 70-1/2, and all payments would be taxable.Small IRAs Will Grow
Even if an IRA is currently small, it will be much larger in the future. Reporting a small IRA as income over the next four years may be painless, but will allow the larger Roth to be entirely income tax free 20-30-40 years from now. A conversion should be almost automatic for younger individuals and individuals in lower tax brackets who expect to be in higher brackets in later years.
"Manufacture" an IRA
What if your AGI will be below $100,000 but you don't currently have an IRA? Many individuals participate in a company qualified profit-sharing plan. The profit-sharing plan could be amended to allow a distribution to individuals who have participated for at least 5 years, even if they are actively employed. The employee could then "rollover" to a regular IRA, which would be immediately converted to a Roth. The profit-sharing benefit would be reported as income, and taxes would be paid (but without a 10 percent penalty). The employee would continue to participate in the company's profit-sharing plan as well.
Important Considerations
To get the full advantage of a conversion, two aspects are critical:
- Taxes should be paid with assets other than the IRA itself. If the IRA is used to pay taxes, the future benefit of the Roth is reduced or eliminated.
- A conversion may not be wise if the individual will be in a lower tax bracket at retirement. Why pay tax now at 28 percent or more, if you will be in a 15 percent bracket at retirement? Be careful about this assumption. Most people assume they will be in a lower bracket when in reality they will not, especially when considering IRA and retirement plan payments which will be received after retirement and will be fully taxable because you didn't convert to a Roth!!