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D. Frank Norton: Is converting your IRA a smart thing?

It's your money

Posted: November 10, 2010 5:25 p.m.
Updated: November 11, 2010 4:55 a.m.

Word to the wise: Look before you leap.

When it comes to IRAs, there are pros and cons to both retirement savings options.

For a traditional IRA, the allowable contributions are tax deductible in the year of contribution and are taxable upon fund withdrawal. There are required mandatory distributions from traditional IRAs starting at age 70 and a half.

In the case of a Roth IRA, contributions are not tax deductible. However, they are not taxable upon fund withdrawal, including earnings, and there is no required minimum distribution at age.

At one point, I personally liked the idea of doing a Roth conversion of my traditional IRAs and SEP plan funds for a few reasons.

Declines in the value of my assets due to stock market declines mean there are less dollars to transfer and therefore to be taxed.

As there is no requirement to start withdrawing funds at a minimum age, I can pull out as much of my Roth IRA funds as I want without having to pay tax on the distribution. This also works well if I need to withdraw funds for an emergency.

A Roth IRA makes a good estate tax strategy, too. I can pass on my Roth IRA to my heirs without them having to pay income tax on any distributions made to them. Distributions are still subject to estate tax, however, depending on what happens in January.

With a traditional IRA, income taxes would have to been paid on any distribution.

For younger investors, it might not make sense to convert a regular IRA to a Roth IRA because with a traditional IRA, a younger person will have many years of tax-free account accumulation before retirement. And then, all of those distributions will be tax free.

Plain and simple, I like the flexibility that Roth IRAs afford me in retirement.

What I don’t like about a Roth IRA is that I must pay taxes on the conversion dollar amounts now.

This is where the deferral to 2011 and 2012 of taxes on those converted funds comes in. I can convert my traditional IRAs this year, but not have to pay the tax on the dollars converted until 2011 and 2012. And I can split the converted amount between the two years.

As the stock market rises again, however, the indexes are at the highest point they have been in a couple of years. If I converted to a Roth IRA now, I would be converting assets which have grown in value and could end up paying more taxes as a result.

If the tax rates are raised for 2011 and 2012, and my overall income is about the same, I could end up paying more taxes in these years than if I paid them all this year, which is a lower tax rate year.

There is some flexibility this year, however, if I do decide to convert now.

If my invested assets in the traditional IRA decline in value after the conversion, I can simply elect to move those funds back to the traditional IRA and treat them as if they had never been moved out in the first place. This move back has to be done by the filing, or extension, date of the return.

Bottom line, there are several moving parts here to consider. Your investment decision should be based on your own personal outlook relating to investment performance and tax rates. I personally am going to take my chances and convert some funds over this year. I said “some,” not “all.”

See your tax adviser for a more concise analysis relating to your personal financial circumstances.

D. Frank Norton is a money manager and financial planner in Santa Clarita. “It’s Your Money” appears Thursdays and rotates between a handful of the Santa Clarita Valley’s financial professionals. His column represents his own views and not necessarily those of The Signal.


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