New Roth Conversion Opportunities: Is Converting a Traditional IRA, 403(b) or 401(k) a Smart Move, Unwise or Much Ado About Nothing?

William Reichenstein
Baylor University
TIAA-CREF Institute Fellow

Douglas Rothermich
TIAA-CREF

Alicia Waltenberger
TIAA-CREF

September 2009 |

Recent tax law changes create an opportunity to consider converting a traditional retirement account to a Roth account for many who have been unable to do so previously due to the significant income limitations imposed on such a conversion. Roth IRA,
Roth 403(b) and Roth 401(k) accounts are essentially mirror images of their traditional counterparts—instead of offering income tax deferral on funding the accounts and income taxation on withdrawal from the accounts, the Roth accounts allow no income tax deferral benefits when assets are contributed to the accounts, but can allow for income tax-free appreciation inside the accounts and tax-free distributions from the accounts. Beginning in 2010, the existing income limitations will be eliminated so anyone with a traditional IRA, 403(b) or 401(k) plan will now be able to make a Roth conversion. While the decision to convert to a Roth account can provide tax savings for some, it is not a wise move for all. Typically the most important consideration is a comparison between the marginal income tax rate in the conversion year and the marginal income tax rate in the withdrawal year if not converted, where this latter tax rate is usually a tax rate from a retirement year. If the future income tax rate is anticipated to be higher, converting to a Roth may be appealing, but if the future income tax rate is expected to be lower, converting may be unwise. When the anticipated tax rates are similar, other factors should be considered, such as required minimum distributions, tax diversification, beneficiary taxation, taxation of Social Security benefits, Medicare Part B premium amounts, and itemized deductions. If conversion makes sense, there are several conversion strategies to consider—converting to top of low tax bracket, recharacterization, and use of non-deductible contributions.

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