Roth Conversion Decision Made Easy

Whether to convert your retirement account(s)¹ to a Roth is not the same for everyone. It makes good sense for some and less for others. But there’s one situation that makes the decision easy:

You have net operating losses.

If you have operating losses in your business — unused losses from 2008 or 2009 or expected losses for 2010 or 2011 — you can use them to offset Roth conversion gains and thereby reduce or eliminate the associated tax bill. You’ll still want your financial advisor to conduct a thorough analysis, but odds are it will make sense to convert.

Even if you don’t have losses, you’ll almost certainly want to convert before year-end if the following apply to you:

1. You have cash outside your retirement account(s) you can use to pay the conversion tax (so you don’t have to pay a 10% early-withdrawal penalty).
2. You won’t need to use the converted funds within the next five years or before you’re 59 ½ (Roth rules).
3. You expect to have “decent” income during your retirement years (and therefore will be in one of the higher tax brackets).
4. You think there’s a greater likelihood that overall income tax rates will be higher in the future, as opposed to lower.

If the above apply to you, definitely talk to your financial advisor about the wisdom of converting your traditional retirement accounts1 to a Roth before year-end (2010).

All this is predicated on a very simple and indisputable fact: You’re better off with your retirement funds in Roth accounts than any other form of retirement account. This is because:

• Withdrawals from a Roth are not subject to taxation. Withdrawals from other types of retirement accounts are taxed as ordinary income.
• There are no withdrawal requirements for monies held inside a Roth. So if you want to leave your money in your account beyond the age of 70 ½, you can — and it will continue to grow tax-free.
• If your heirs inherit your Roth, their withdrawals are also tax-free.

These are serious advantages. The proverbial fly in the ointment, of course, is that money and/or investments moved from traditional retirement accounts, i.e., traditional IRA, SEP IRA or Simple 401(k), to a Roth is subject to taxation. This is because, as you will recall, you funded the accounts with pretax dollars.² Roth accounts work the opposite way: Contributions are made with after-tax dollars³ and withdrawals are tax-free. Withdrawals from other types of retirement accounts are taxed in the year of withdrawal as ordinary income.

So the benefits of having your money in a Roth are considerable, but moving funds from traditional accounts to the Roth will trigger a tax bill. Which tactic makes the most sense for you depends on your particular situation. The core decision criteria are listed above.

If you convert this year (2010), you can allocate any taxes due to the 2010 and 2012 tax years. Talk to your financial advisors today.

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¹ Funds held in 401(k) and Solo 401(k) accounts (at least funds in these account types that did not originate from profit share contributions) cannot be moved to a Roth outside of a “distributable event” such as discontinuation of the plan, severance of employment, retirement, or reaching age 59½.

² If you have made after-tax contributions, they — and investment gains on these contributions — are not subject to taxation when moved to a Roth.

³ Most contributions are made with pretax dollars but after-tax contributions can be made, too.²