IRA Value Down…Convert to Roth IRA

Everyone hates to see the value of their retirement nest-egg decline. However, some taxpayers may be able to make this down market work to their advantage. While the value of your IRA is reduced, less income tax will be required to convert to a Roth IRA. Because earnings in a Roth IRA are tax-free, when the stock market goes up, all the appreciation in the Roth IRA will never be taxed. If the stock investment remains in the traditional IRA when the market rallies to a higher value, the earnings are taxed as ordinary income when withdrawn. Paying tax today on a lesser amount may save a tremendous amount of future taxation.

Tax on Conversion

When you convert funds from a traditional IRA to a Roth IRA, you are required to pay income tax on the traditional IRA funds that have not been taxed before. This would include deductible or pre-tax contributions and any interest, dividends, or appreciation earned within the account. Any non-deductible contributions to the traditional IRA would not be taxed if converted to a Roth IRA, since those dollars were already taxed.
Eligibility to Convert

Those with adjusted gross income less than $100,000 (married and single taxpayers) can convert existing traditional IRAs to a Roth IRA. Income taxes would be due on untaxed funds in the year of the conversion. Therefore, it is important that you consider the income tax impact as you determine the amount to convert. You can convert all or a portion of your traditional IRA in any one year. You can convert additional amounts in any future year as long as you qualify based on your modified adjusted gross income.

Heads up…beginning in the year 2010, anyone can convert funds in a traditional IRA to a Roth IRA regardless of income level. This provision was included in the Deficit Reduction Act of 2005. In addition, the income recognized from the conversion in 2010 can be reported evenly across the years 2011 and 2012 unless the taxpayer opts to have all income taxable in the year of conversion.

Benefits of Roth IRA

Any amount of an IRA, partial or total, can be converted. Once the Roth IRA has been in existence for a minimum of five years and the owner is at least 59 ½ years old, all income distributed from the Roth IRA is income tax free. Currently the law also allows the same tax-free characteristics of the Roth IRA to be inherited by spouses and the next generation. There is no minimum distribution required from a Roth IRA when the owner reaches 70 ½ years of age. This is also the case if a spouse inherits a Roth IRA. However, if the next generation inherits the Roth IRA, a minimum distribution is required beginning one year after the IRA owner’s year of death and based on the heir’s age.

Benefit of Conversion

If you have adjusted gross income under $100,000, you should give serious consideration to converting some portion of your traditional IRA to a Roth IRA. The benefits include:

• Taking advantage of reduced market value to pay less tax on conversion.
• Paying no tax on future appreciation of investments now in a Roth IRA.
• Avoiding potential of higher income tax rates in the future due to either taxpayer’s increased income or increased tax rates.

Conversion Example

Assume a married taxpayer has adjusted gross income of $80,000 and, therefore, is eligible to convert in 2008. If the taxpayer has deductions and exemptions of $15,000, the amount of taxable income is $65,000. The 2008 marginal tax rate for a married filing joint taxpayer is 25% for taxable income from $65,100 to $131,450.

Let’s further assume that the traditional IRA valued at $50,000 today was worth $90,000 a year ago. If the total IRA amount of $50,000 is converted, the additional federal tax would be $12,500. To convert a $90,000 IRA, the federal tax would be $23,210 ($66,350 at 25% and the balance at 28%). At the reduced IRA value of $50,000, the entire IRA can be converted for almost half the tax cost of the $90,000 value. No one knows how long it will take for the market to recover, but the majority consensus suggests that it will. With the funds now in a Roth IRA, all future appreciation will be totally tax-free.

In our example, we did not include the payment of state and local income tax that would be required on any conversion amount. Since the payment of taxes must be paid with the April 15th tax return or before, the impact on cash flow must be considered. For this reason, it may be prudent to convert a lesser amount. If the taxpayer converts $10,000 or 20% of a traditional IRA, the additional federal tax would be $2,500.

Timing May Be Perfect

If you are eligible to convert and if the extra taxes can be paid without jeopardizing your financial situation, then consideration should be given to converting some portion of your traditional IRA to a Roth IRA. Taking advantage of the low stock market value can allow you to reap huge tax benefits in the future. Why not make lemonade out of lemons!


Elaine E. Bedel, CFP, is president of Bedel Financial Consulting, Inc., a wealth management firm providing fee-only financial planning and investment management services. For more information visit their website at www.BedelFinancial.com or email to ebedel@bedelfinancial.com.