Lynn Brenner's Family Finance

Does a Roth IRA Conversion Really Make Sense?

That's the subject of my article in the March/April issue of AARP Magazine, titled 'Roth Mania!'

You can read that article here. 

The answer obviously depends on many variables, and I think that one of them doesn't get enough attention:

How soon will you have to spend the money you convert from a traditional IRA to a Roth IRA?

(Given my druthers and more space, I'd have devoted a couple of additional paragraphs of 'Roth Mania!' to that question alone.)

A Roth conversion has a price tag -- the income taxes you pay on the money you transfer from your traditional IRA into the new Roth IRA.

You won't come out ahead unless your new Roth IRA earns more than enough to cover that initial cost. That's going to take time -- and a decent investment return. Sure, a Roth IRA's earnings are tax-free. But even tax-free, an abysmal return is abysmal.

Some of the articles I've read quote financial advisers who suggest -- or at least imply -- that five years may be long enough.

I think that's much too optimistic. 

In 'Roth Mania!' I wrote that it's going to take at least ten years for your Roth IRA earnings to exceed the cost of the conversion, and I wish that the words at least had been italicized. 

If you believe that's overly cautious, consider the stock market's performance over the ten years that just ended. From the end of 1999 to the end of 2009, stocks traded on the New York Stock Exchange lost an average of 0.5% a year. It was the worst calendar decade for stocks in the past 200 years.

Many investors still haven't recovered from the shock. After all, in the previous decade --from 1989 through 1999 -- stocks earned an average 17.6% a year. And no matter how often we heard (and in my case, wrote) that those splendid annual returns were much higher than the long-term average, they grew to seem normal.

I'm not suggesting that this decade will be as bad as the last one. (God forbid!) I'm just pointing out that the market can deliver considerably less than its historic average annual return of about 10% to 11%.

When you calculate whether or not a Roth conversion is worthwhile, I wouldn't assume a more than 10% average annual investment return going forward. If you want to play it safe, figure on a more modest 6% return if you invest in stocks, less if you invest in bonds.

 

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.(c) Lynn Brenner, All Rights Reserved

 

Roth IRA Conversions and Buyer's Remorse: How Often Can I Change My Mind About A Conversion?

Q: I am in the process of converting a traditional IRA to a Roth IRA. If I later find it desirable to recharacterize, is there any waiting period before I can re-convert the account into a Roth? -- LW, via email

A: Yes, there is.

But let's start by filling in the background for everybody else.

When you convert a traditional IRA into a Roth IRA, you must pay income taxes on the amount you convert. (In a special one-time deal, if you do a conversion in 2010, you have the option of either declaring the conversion in your 2010 income tax return, or dividing it between your 2011 and 2012 returns.)

Why would you want to do a conversion? Because your earnings and withdrawals in the traditional IRA are only tax-deferred. You'll pay taxes on them when you start tapping the account. By contrast, your future earnings in the new Roth IRA will be tax-free; and so will your withdrawals from the Roth IRA, after you're 59 and a half years old and have owned the account for five years.

(Even so, Roth conversions aren't a no-brainer. In a future post, I'll discuss their pros and cons. For now, let's stick with your question.)

Let's say you're converting a $100,000 IRA -- and let's keep it simple by assuming that you plan to include that $100,000 in your 2010 taxable income rather than spread it over future tax years. We'll assume the tax on the $100,000 conversion is $28,000. You'll pay it when you file your 2010 return in April 2011.

Then after doing the conversion, you decide it was a bad idea. Maybe the market has tanked and by September, your $100,000 account is worth only $80,000. With a sinking heart, you realize that makes no never mind to the Internal Revenue Service: Come April 2011, you'll still owe the $28,000 tax on a $100,000 conversion.

Can you avoid that tax?

Yes. You can wipe the slate clean by turning your new Roth IRA back into a regular IRA. This is called a `recharacterization.'

You're allowed to recharacterize a 2010 Roth conversion right up until the final due date of your 2010 income tax return. With extensions, that means you have until October 15, 2011 to recharacterize a 2010 Roth conversion. (If you don't decide to recharacterize the account until after you're paid your 2010 taxes, you can file an amended 2010 return and get a refund for the $28,000 tax you paid on the conversion.)

Your question is, what if you change your mind again? How soon can you turn that account back into a Roth IRA?

Not until the year following the original conversion, or the 31^st day after the recharacterization, whichever comes later, says Barry C. Picker, a Brooklyn, New York tax accountant and IRA expert.  

In other words, if you do the conversion this month, and then recharacterize your Roth IRA in November 2010, you'll be able to reconvert it as early as January 2011. If you don't recharacterize your 2010 conversion until, say, May 1, 2011, you'll be able to reconvert thirty days later -- on June 1, 2011.

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.(c) Lynn Brenner, All Rights Reserved