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Roth IRA Conversion Points to Consider
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It seems that nearly every day, some sort of advertisement, article or
promotion regarding the 2010 changes for Roth IRA conversions comes our
way. This is a potentially great option for some individuals. However,
most of what we see looks more like a sales pitch than real financial
advice.
The dominant IRA conversion logic is to pay tax now, convert to a Roth
IRA and avoid tax on future IRA distributions. The avoidance of tax on
interest and gains alone could make the conversion worthwhile. The
counter-logic of the conversion is that you may be paying conversion
tax at a higher rate while working than you would during retirement.
To
complicate the discussion further, consider the source of the funds
needed to pay the conversion tax. Once paid to the Government, that
money is no longer available to generate interest or investment gains.
That is the opportunity cost of prematurely paying taxes.
Which brings us to Roth conversion Rules:
* Rule #1 - Never pay the conversion tax from your IRA. Put
simply, if you don't have the funds available outside of your
IRA, don't convert. Shrinking a tax-deferred account to pay
tax and avoid future taxes is math that does not work well.
* Rule #2 - The tax payment is certain. In other
words, your future income and taxes are uncertain, as are your future
investment returns. But the tax payment to make the IRA conversion is
certain, so you should have a strong case and convictions about your
future situation.
* Rule #3 - Don't convert near the start
of distributions. The primary Roth advantage is that all interest and
earnings are tax free at withdrawal. Thus, it is important to give
those assets time to accrue gains and the tax advantages. I generally
consider seven to ten years to be sufficient.
* Rule #4 - Create a balance of tax-deferred and
tax-free retirement income - traditional IRAs providing the
tax-deferred income and Roth IRAs providing tax-free income.
Be Wary of Broad Advice
The mass of articles and examples surrounding
Roth IRA conversions seem to suggest that there is a way to offer good
financial advice via an article or newsletter. However, too much of the
discussion has focused on why to convert your IRA to a Roth, with very
little effort on why not to convert. Good financial advising seeks to
illustrate pros and cons and enable individuals to make informed
decisions. Use this broad advice as a starting point when considering
your retirement.
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