Personal Finance

Why You Should Not Convert Your IRA to a Roth

For years I’ve been warning you not to take your IRA and convert it to a Roth IRA. The reason is very simple: Converting your IRA to the Roth does not increase your wealth. All it does is accelerate your tax payments.

When you convert your IRA to a Roth, you pay taxes on the full value of that IRA today instead of paying it later when you withdraw money in retirement. Don’t believe me? Ask someone who chose to convert in early 2008 and was forced to pay a big tax bill for money that doesn’t even exist anymore since the account value has declined.

Here’s an illustration: Let’s say that on January 1, 2008, you had $100,000 in your IRA and you converted it to a Roth. Naturally, you had to pay taxes on that $100,000. If, between combined state and federal taxes, you are in the 40% tax bracket, that means you had to pay $40,000 in taxes.

But what if you had converted at the end of 2008, after the S&P has fallen 38.5 percent? That means your $100,000 investment would have declined to only $61,500. Therefore, the tax liability would have been $24,600 instead of $40,000.

In other words, by converting at the beginning of 2008 instead of the end of 2008, you would have forced yourself to pay an extra $15,400 in taxes unnecessarily.

Luckily, if you’ve made this mistake in 2008, there is a way to undo it. It’s called a recharacterization. It lets you undo the IRA conversion and move the money back to your traditional IRA. In the process, you undo the tax liability, too.

If you have not yet filed your 2008 tax return, recharacterize by October 15, 2009, and file your return.

If you’ve already filed your 2008 tax return, you have until October 15, 2009 to recharacterize Then file an amended return to get back the taxes you paid on the original conversion — but be sure to talk to a tax advisor for help. And, if you’re a glutton for punishment, a tax advisor can also help you determine when it’s legally okay to move the money back into your Roth. But I’d prefer you stick to a deductible IRA.

Ric Edelman is Chairman and CEO of Edelman Financial Services LLC, which manages billions of dollars for individuals and families nationwide. Ric is a frequent On the Money contributor and the author of seven books on personal finance, including his new #1 Bestseller, RESCUE YOUR MONEY.