Year-end Planning

Should you make that Roth IRA conversion? It's complicated ...

Jennifer Woods, special to

To convert or not to convert ... That is the question.

As 2015 winds down and people take stock of their finances, a question many are facing is whether to convert their traditional IRA to a Roth IRA. Unfortunately, the answer is not as simple as one might hope.

The tax rules that govern IRAs are complicated and tend to change frequently, which means that if you're considering a conversion, you'd better be ready to do some homework to make sure it's the right move.

Geri Lavrov | Getty Images

In a nutshell, traditional and Roth IRAs are retirement accounts that allow you to contribute money ($5,500 a year in 2015, plus an additional $1,000 if you're over age 50) that grows tax-free over time.

With traditional IRAs, contributions may be tax-deductible — depending on factors such as income levels and whether you have a work-related retirement plan. When you begin taking required minimum distributions, which must start at age 70½, you have to pay taxes on withdrawals.

With Roth IRAs, you pay tax on that income when you first make your contribution. If the withdrawal is made before 59½ and is only up to the amount that has been contributed to the Roth IRA, then no income tax is charged. Withdrawals of contributions are tax-free.

Roth IRAs are not subject to the RMD rules, since no distributions are required during the lifetime of the owner. However, Roth IRAs are subject to RMD rules after the death of the owner of the Roth IRA, with a 50 percent penalty if such distributions are not made.

Roth IRAs have income limitations; for instance, to contribute this year, your modified adjusted gross income for a married couple filing jointly must be less than $193,000.

How to make the most of your required minimum distribution

There are ways to get around the income caps, but before getting to that point, experts say the first question is whether a Roth even makes sense for you.

"The big decision point is: 'What is your current tax bracket, and what do you expect it will be when you retire?" asks Rande Spiegelman, vice president of financial planning with Schwab Center for Financial Research.

I've seen very few cases where it makes sense to be invested completely in a traditional IRA or completely in a Roth.
Andy Martin
president of 7Twelve Advisors and principle with Gerard Securities

"It's a simple question, but it's not that simple to answer," he said. "Most people don't even know what their current tax bracket [is], let alone what the future will hold."

Typically, if you're young and in a lower earnings bracket than you expect to be later in life, a Roth may make sense — you'll forgo tax deductions now, but later, when you're in a higher bracket, you won't pay taxes on distributions.

"You'd better believe you're in a lower tax bracket today than you will be when you withdraw the money," said Spiegelman, adding, "Because as the saying goes 'Never pay a tax today that you can postpone to tomorrow.'"

Spiegelman explained, "If you're paying a tax early, you'd better have a good reason for it."

The question of whether a Roth makes sense gets trickier when you're older or have less clarity about what the future holds — for your tax bracket and tax rates.

"It requires a lot of number crunching," said Andy Martin, president of 7Twelve Advisors and principle with Gerard Securities. "You should have a CPA do a calculation of what is the better after-tax net return."

Because it's hard to predict where tax rates will be in the future, Martin suggests having both a traditional and Roth IRA. "I've seen very few cases where it makes sense to be invested completely in a traditional IRA or completely in a Roth." He suggests splitting contributions in half.

For most people, the decision comes down to taxes; however, that may not be the case with wealthier people, who are attracted to Roths because they don't have distribution requirements, which means their money can continue to compound tax-free until it's needed or can be passed down to their heirs.

What to do after these retirement funds hit goals?

If you've done the math and a Roth seems to make sense, the next question is how to fund it. If you're young with no other retirement accounts, it's pretty straightforward.

However, for those looking to convert large traditional IRAs to a Roth, it's more complicated and essential that you understand the tax implications before pulling the trigger.

"If you're going to make a conversion, you have to pay taxes on that," said Stein Olavsrud, a certified financial planner and vice president at FBB Capital Partners. "You should be able to pay those taxes from outside of the IRA.

"You don't want to [diminish the value of your] IRA to pay the IRS," he added.

Additionally, Olavsrud said, the money you convert — and there are no limits on how much you're allowed to convert — counts as income, which could potentially drive you into a higher tax bracket. So you should know where you sit in your current tax bracket and determine how much you can convert without pushing yourself into a higher one. (To make things more complicated, certain states also have high taxes, which need to be accounted for, as well.)

According to Martin of 7Twelve Advisors, if you have a very large IRA, "you're simply not able to convert the whole thing without kicking yourself into a higher tax bracket."

He recommends spreading it out over three to four years. However, he added, you don't need to convert it all. "I don't believe the end goal should be to get completely out of a traditional IRA, but to balance it out."

Timing may also play a role in deciding when to do a conversion.

For instance, Olavsrud at FBB Capital Partners said that it's more advantageous to do it during a year when your income is lower or when the market is down, lowering the value of the assets in the account.

Additionally, he said, "if you're a business owner with a net operating loss for your business, you can use a conversion to offset that loss without having to bear the tax burden."

What to do if you have a crummy 401(k) plan

Those who want to contribute annually to a Roth but exceed the income cap may also take advantage of a loophole in the tax law by doing a backdoor conversion, which entails contributing money to a traditional, nondeductible IRA each year and then immediately converting it into a Roth.

Backdoor conversions, though, can create some tax consequences of their own if you own any other IRAs that hold tax-deferred money, such as a rollover IRA. The reason is that, even if you are making a contribution to a nondeductible IRA and then converting it to a Roth, the IRS looks at all IRAs as a single account and will tax you on the portion of the assets that have not yet been taxed. (There's a good chance backdoor conversions will be eliminated altogether under the fiscal 2016 budget.)

There are many advantages to Roth IRAs, and for many people they can be a great retirement savings vehicle. However, the tax laws surrounding them are very complicated, so before jumping into a conversion, make sure you've done your due diligence or it could end up costing you in the end.

— By Jennifer Woods, special to