To Convert or Not; You Decide

groceryFolks who know me, know that I tend to be on the competitive side. It is not surprising that I look at grocery shopping differently than most. It is not social hour to me; frankly, it is work. When I walk into a grocery store, I look at each area of the store as a set of stations. You have the fruit and veggie station, the milk station, the bread station, cold cuts, etc. You get my point. Grocery shopping is a challenge to me. I like to time myself to see how I can tackle each station quickly and efficiently and get out of there as fast as possible.

On Monday, Jill needed to wrap presents for Christmas so she sent our three girls and me on a field trip to Stop & Shop (Frankly, I think she was seeking some peace and quiet since the girls were all wound up for Christmas).

So, off we went. We entered the store, and began tackling each station with ease and precision. Veggies, then cold cuts, fish, it seemed like we were going to beat our best time of 22 minutes. While grabbing milk and rounding our carriage into the frozen food isle on two wheels, I bumped into a client of ours who wanted some advice on whether or not to convert their traditional IRAs to Roth IRAs. While I may despise grocery shopping, I love to help folks navigate the muddy waters of personal finance. This is what we discussed.

A Roth IRA conversion moves assets from a Traditional IRA or employer plan to a Roth IRA. Normally, contributions to a Traditional IRA or employer plan have not been taxed by Uncle Sam, whereas, contributions to a Roth IRA are made on an after-tax basis. Therefore, when a Roth IRA conversion is made, it triggers a taxable event and income tax is paid on the entire amount of assets being converted. In nearly all cases, the money to pay the tax on a Roth IRA conversion should come from outside (non-retirement account) funds in order for the conversion to make sense. Your ability to pay that tax with outside money will go a long way in determining whether a Roth IRA conversion is right for you.

There are also many other pros and cons to consider before deciding whether to convert a Traditional IRA (or employer sponsored plan) to a Roth IRA. If you have an immediate need for funds or rely on them to continue your current standard of living, then a Roth IRA conversion is probably not for you since there are certain restrictions on withdrawals. However, if you have no immediate need for the funds, a Roth IRA conversion is potentially a great way for the funds to grow tax-free over your lifetime.

If you believe your income tax rate will be the same or higher in retirement, then converting funds to a Roth IRA makes more sense, since you will either be paying tax on a smaller amount of money (before it has grown) and/or paying the tax at a lower rate. On the other hand, if you think your income tax rate will be much lower in retirement, you may want to forgo a Roth IRA conversion and take advantage of lower tax rates in a later year.

You may also want to make a Roth IRA conversion if you have favorable tax attributes such as large charitable deductions or net operating and tax credits, which would offset the income tax on conversion. Also, you may benefit from not having to take required minimum distributions starting at age 70 ½, or from having the ability to make contributions even after age 70 ½ if there is eligible earned income. Furthermore, a Roth IRA can provide an income-tax-free inheritance for any heirs.

Some folks choose NOT to convert to a Roth IRA because they have an aversion to paying the income tax up front. Some choose NOT to convert because they do not trust that the government will keep their tax-free deal. Also, if you have both taxable assets and tax free assets, you would want to leave tax free assets, such as a Roth IRA, to loved ones and leave taxable assets to a charity since charities are tax free anyways.

Lastly, it is important to be cautious of the new 2013 Obama Care Taxes, specifically the extra 3.8% tax on investment income, the 0.9% extra Medicare tax on wages and self-employment income, the increase in capital gains tax and the phase out of Schedule A itemized deductions. Make sure to check with your financial professional to ensure that a conversion does not make you an unintentional victim of these extra taxes.

While the girls and I may not have beaten our grocery shopping record of 22 minutes this Christmas season, we successfully helped some very nice folks navigate those muddy waters of personal finance. What’s better than that!

Jill, Susan, and I have enjoyed spending 2013 with you. We wish all Cutter Family Finance readers and their families a Happy New Year.

Make sure in 2014 to be vigilant and to stay alert, because You Deserve More!

Do you have a specific question for Jeff? If you don’t want to camp out in the grocery store isle hoping to bump into him, just request a free, no-risk, no-commitment consultation!

Photo courtesy of Microsoft Office