If you’ve been obsessively reading personal finance news like I have, you know that the eligibility rules for Roth IRA conversions are changing in 2010 and that some people are getting quite excited about it. The current $100,000 income limit for conversion will be gone starting 2010. As an added bonus, converters in 2010 have the option of dividing their conversion income over two years (2011 and 2012, curiously skips 2010).
So, I’m not going to write a long post about all the factors that go into whether you should convert. You can read what Vanguard and Fidelity has to say about that. What I am going to do is discuss what is typically missed and share a simple calculator I plan on using next year to help me decide whether to convert.
Most articles, when discussing the financial benefits, primarily stick to the trade off between prepaying your income taxes now at current rates vs paying your taxes later at estimated future rates. This analysis works fine in many situations. However if you can afford to pay the conversion tax with outside savings and typically max out your contributions to tax-advantaged accounts, the analysis is incomplete. By paying the tax with outside money, you are effectively making an indirect contribution to a Roth IRA that does not count against any contribution limit. This can be a material benefit of converting, even outweighing slightly higher future tax rates.
The calculator below assumes that the Traditional IRA you are converting is composed of fully deductible contributions. It also assumes that you can afford to pay the taxes due on the conversion amount, and that the money set aside for taxes would be invested in a taxable account if you decide against converting. This is the key reason why a calculator is needed. The calculater takes these assumptions as inputs:
- Current income and capital gains tax rate (federal and state)
- Income tax rate during retirement (federal and state)
- Amount to convert
- Years to retirement
- Investment return
- Dividend Rate
- Holding period for the taxable account (assumes 1+ yr)
This calculator does not consider the option value of waiting to convert later. If the benefit of converting now is not dramatic and there’s a decent chance that your tax rate may drop in the near future, waiting to convert then may be the best option.
Relevant links: