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As Market Tumbles, Time to Convert Traditional IRA to Roth?


There’s one way for people saving for retirement to use the market’s tumble as a force for good: Convert battered assets in your traditional individual retirement account to a Roth IRA.

Roths, you may recall, are retirement accounts in which you invest after-tax dollars and get tax-free withdrawals – and you don’t have to take them on a mandatory schedule, as you do with a traditional IRA. As of last year, there’s no income limit for moving money to a Roth from a traditional IRA or employer-sponsored retirement plan.

The catch is that you would owe income tax on the amount you convert for the year in which you do the conversion. And it’s generally best to use money outside your IRA to pay that tax. So, if you convert investments when they dip in value, you pay tax on a smaller amount – and have the potential for more tax-free growth in the future.

Converting to a Roth can also be a good estate-planning strategy. Although your heirs would have to take distributions from an inherited Roth each year, they don’t have to pay any tax on that income. And the money you use to pay the conversion tax, of course, is out of your future estate as well.

A few things to keep in mind: You can’t cherry-pick any after-tax contributions you’ve made to your traditional IRA over the years to convert. Instead, you get credit, proportionately, for after-tax money in your IRA. Here’s an example: You have $250,000 in IRA assets, including $200,000 in a rollover IRA from a 401(k) and $50,000 in another account, including $40,000 in after-tax contributions. That means 16% of a conversion would be tax-free.

Also, a conversion will raise your overall income, which could push you into a higher tax bracket.

Ed Slott, an IRA consultant in Rockville Centre, N.Y., suggests a good conversion strategy in a time of volatility: Put each different type of asset in a different Roth account. That way, if any asset class falls significantly in value, you can “recharacterize” that specific type of asset as a traditional IRA.

Keep in mind, though, that there’s waiting period after a recharacterization before you can convert again.

We wrote more about this strategy, along with other moves to take advantage of the downturn, in the Weekend Investor cover story.

What moves are you making with your retirement investments to capitalize on the carnage?


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    • Converting a traditional IRA to a Roth IRA is an appealing option for individuals who believe their retirement income will be taxed at a higher rate than their current income. When you convert your traditional IRA to a Roth IRA, you have to pay tax on that money. Therefore, you must have enough savings outside your IRA to pay the tax on the converted amount. If you use the IRA assets to pay the tax, the benefit of converting to a Roth IRA may just about evaporate.

    • As everyone knows, any future Congress can start taxing Roth distributions, either directly or indirectly (e.g. by counting them in the income used to calculate Medicare B premiums). So you may have the experience of paying tax now when converting, and again when you take distributions. Any Roth is a gamble, and this is doubling the gambling.

    • with all the market turmoil, our combined Traditional IRA’s are down 3% since July 31 and 6% from the high on May 31. If we convert (we are in our mid-70′s) it will throw us into the next tax bracket and what will we have saved? We are staying with the Traditional IRA’s and taking the RMD’s as required. Yes, we pay tax on those RMD’s but so what? e look at the IRA’s as a money machine albeit that combined they only yield us about $17K taxable income which is useful for a vacation or a home improvement. The RMD’s are not part of our retirement planned income.

    • I think you might be wrong or a little vague on an important paragraph in this article. If you have a 401k w/both after-tax and before-tax contributions, the IRS has been vague (maddeningly so), but it appears that there is a defensible strategy to convert the after-tax into a Roth IRA and the pre-tax (and growth) into a traditional IRA and get the best of both worlds. If you look at Natalie Choate or Ed Slott, they both believe this is possible/defensible, with the caveat that the IRS has been slow to make public its take on this. There are several ways to accomplish this, but they seem to indicate that one in particular is the most defensible.

    • Good comments; Future obama tax increases is another reason.

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  • Encore examines the changing nature of retirement, from new rules and guidelines for financial security to the shifting identities and priorities of today’s retirees. The blog also explores news that affects retirement, from the Wall Street Journal Digital Network and around the web. Lead bloggers are reporter Catey Hill and senior editor Jeremy Olshan. Other contributors include The Wall Street Journal’s retirement columnists Glenn Ruffenach and Anne Tergesen; the Director for the Center for Retirement Research at Boston College, Alicia Munnell; and the Director of Research for Pinnacle Advisory Group, Michael Kitces, CFP.