Question: Should I convert my traditional, tax deferred IRA to a tax free Roth IRA?

First, yes, this option exists. You are able to convert your traditional Individual Retirement Account (IRA) to a Roth IRA.  BTW, before 2010 funds in a traditional IRA were not allowed to be converted to Roth IRA if your Modified Adjusted Gross Income (MAGI) was over $100,000.

So, why and when should you consider conversion? What are the tax benefits involved? When does it not make sense to convert? These are some of the questions we will address in this blog.  The following are some of the factors to take into account when considering conversion from Traditional to Roth IRA:

1. Do you have cash to pay for the taxes due after conversion to Roth?
In a traditional IRA you accumulate money in an account with pre-tax dollars i.e. you have zero basis in the money and the earnings. In a Roth IRA you do the opposite i.e. you accumulate money post-tax and earnings grow tax-free. Your basis is in what you’ve contributed and the earnings, as well.

What happens when you convert? You pay tax on the amount of your conversion as if it were ordinary income in the year of conversion. The bottom line is, your current tax obligation will go up in the year you convert, so have funds ready to fulfill your tax obligations.

2. Are you younger than 59.5 years old and likely to withdraw cash from the Roth IRA within 5 years, after you convert?
‘Qualified distributions’ from a Roth IRA are tax free however, if you are under 59.5 years of age and withdraw cash within five years after the conversion is made it will not count as a ‘qualified distribution’. There would be a 10% additional tax if distributions were made within 5 years of conversion. But if you have reached the age of 59.5 years this 10% additional tax is not levied. So, bottom line, convert only if you know you do not need the money for the next 5 years.
For detailed information on this please refer to:

3. Are you currently in a high tax bracket and expect to be in a lower tax bracket when you are older and ‘qualified’ to withdraw the distributions?
If yes, a traditional IRA might make more sense.  It would depend on whether contributing to a traditional IRA now would bring down your AGI and consequently your tax liability.  In retirement, when you are in a lower tax bracket, the distributions you take would be taxable at the lower tax rates.

4. Do you have heirs and want to pass on money to them tax free?
In a traditional IRA the IRS forces you to withdraw “Required Minimum Distributions” or RMDs each year and pay taxes on those RMDs. In contrast, distributions from a Roth IRA are at your will. You are not forced to withdraw cash and can leave the money in the Roth IRA for as long as you want. Consequently, it can be passed on to heirs of the deceased. If you know that you are going to be financially solid on retirement, don’t need to supplement income with IRA distributions and want to leave tax free money to heirs then consider conversion to Roth IRA.

5. What if the tax rates go down or up?
Due to the deal on taxes in 2012, there is a some visibility on tax rates So, if you’re comfortable with the tax rate currently and feel that you’ll be earning more in the future then OK if you want to convert now.

6. What if I convert and then decide it was not best for me after all?
If you decide, after the fact, that the conversion from traditional to Roth IRA was not a good decision and want to reverse it, you have until October 15th of the subsequent year to re-characterize a current year conversion. The idea is that a conversion is not ‘one way traffic’ (up to a point) and you can go back and undo the conversion if it seems it is better to do so in hindsight.