It seems everyone suggests you convert your Individual Retirement Account to the new Roth IRA. Should you? If you do, there is a window of opportunity open through December 31 that allows you to spread the conversion tax over four years. After that date, you pay it all in one year.

As you know, the traditional IRA usually gives deductions for contributions and tax withdrawals. Whereas, a Roth gives no deductions for contributions but exempts earnings.

If you convert (i.e. rollover) all or part of your current IRA to a Roth, you will owe income taxes but no early withdrawal penalty. If you do this prior to January 1, the conversion income can be spread over 4 years: one-fourth this year and in each of the next three years. For example, consider a $20,000 IRA where you deducted all the contributions. You include $5,000 in income this year and $5,000 in each of the next three years. If the contributions, however, had been nondeductible, with earnings of $4,000 you include $1,000 in income this year and $1,000 in each of the next three years.

Note, only taxpayers with adjusted gross income of less than $100,000 are eligible to convert.

Following is a general comparison of a Roth and a traditional IRA where you have deducted the contributions, followed by reasons for and against converting:

Tax Advantage

• Traditional gives a deduction for contributions but taxes earnings when withdrawn.
  
• Roth gives no deduction for contributions but permanently exempts earnings.
  

Note, there is a trade off, one exempts from taxes the other postpones taxes but on a larger amount. With a Roth, taxes on earnings are exempt; with a traditional, taxes on earnings and the $2,000 annual contribution are postponed.

Annual Deduction Or Contribution Limited By Income

• Traditional allows a $2,000 deduction. But if the taxpayer participates in a company retirement plan at work, the deduction phases out as Adjusted Gross Income increases. It starts phasing out for joint filers at $50,000, for singles, $30,000.
  
• In a Roth, with or without company plan participation, the $2,000 contribution, which is non-deductible, starts phasing out for joint filers at $150,000, for singles, $95,000.
  

Note, traditional is available even to high income taxpayers if they aren't participating in a company plan.

Penalty On Withdrawals

• For traditionals, withdrawals are subject to a 10 percent penalty unless taken out after age 59 ½ , death or disability or they qualify as periodic annuity payments. Funds may also be withdrawn on a limited basis for medical expenses, a first home or college expenses. Withdrawals must start at age 70½ .
  
• For Roths, there is no penalty on withdrawal of contribution. Withdrawal of earnings are subject to a 10 percent penalty unless Roth is at least five years old and funds are withdrawn after age 59 ½, death or disability or on a limited basis for a first home.
  

Note, with the Roth there is no requirement to withdraw any portion at any age.

Tax on Withdrawals

• Traditionals are taxed on withdrawals, except for nondeductible contributions.
  
• Roths are not subject to tax on withdrawals of contributions. As to earnings, there is no tax on withdrawals if Roth is at least five years old and funds are withdrawn after age 59 ½, death or disability or on a limited basis for a first home.
  

Note, the first money withdrawn from a Roth is considered from contributions and therefore nontaxable.

Reasons for Converting

• You are in a lower tax bracket now than you expect to be when you plan to withdraw the funds.
  
• Roth gives more flexibility:
  

- Withdrawal of contributions allowed any time.

- No mandatory withdrawals at age 70½.

- Contributions can be continued beyond age 70½ .

Reasons for Not Converting

• You expect to be in a lower tax bracket when you plan to withdraw the funds.
  
• No one can predict what the tax code will look like in the future. If Congress shifts the tax burden to a sales tax, rolling over to a Roth and paying the income tax may be a huge mistake.
  
• You don't have sufficient funds outside the IRA to pay the conversion tax. By using IRA funds, you will have a smaller tax free investment.
  

Note, the decision whether or not to convert may be difficult. There is no easy formula. Study the pros and the cons to see which ones are most important in your situation.

A.J. Cook is a lawyer and CPA. His tax column appears weekly in numerous newspapers. Why isn't it published in your hometown newspaper? Ask its Business Editor to subscribe.

Copyright © 1987-2001 A.J. Cook All Rights Reserved
This information is not intended for use without professional advise.
Disclaimer
Released 8-31-98