From tax-deferred to tax-free
By converting a Traditional, SIMPLE or SEP IRA to a Roth IRA, and paying income taxes on the current account value, your savings can continue to accumulate free from taxes. After the taxable five year period, beginning with the first year that you made a contribution to the Roth IRA, any qualified withdrawals from the account, including accumulated earnings, are tax-free.
It's a question of paying now or paying later. For many investors, paying taxes up front will reap large tax savings in the future.
The Potential Benefits of a Roth IRA Conversion
Over 15 years at an 8% annual rate of return
 If you convert a $100,000 Traditional IRA to a Roth IRA, you'll have to pay $28,000 in taxes (assuming a 28% bracket) — taxes that ideally should be paid out of your pocket, not your IRA. If you dip into the IRA to pay the taxes, you will have to pay a 10% penalty tax on that amount (if you are under age 59½).
With a hypothetical 8% annual return rate compounded annually, your $100,000 Roth IRA will be worth $317,216 in 15 years, with no taxes due on that amount. Remember, you paid all the taxes you owed when you converted the account.
What if you had not converted your IRA. As with the Roth, your Traditional IRA would have grown to $317,216 after 15 years as well. But you'll owe taxes on that amount if it is distributed to you — almost $80,000 assuming a tax bracket of 25%. After taxes are paid, you are left with only $237,912.
Of course by not converting the Traditional IRA, you may have invested the $25,000 that was due for the initial taxes on the Roth IRA conversion. But even if that grew at the hypothetical rate of 8% (paying taxes along the way), your total value would be only $297,827 (237,912 from the Traditional IRA plus $59,914 from the taxable account) — almost $19,000 less than the hypothetical Roth IRA conversion account balance.
Why Voluntarily Incur This Tax Liability?
When you convert to a Roth IRA, income taxes will be due on any deductible contributions and all earnings that have accumulated in the Traditional IRA. Though a Roth IRA conversion can be done without any early withdrawal penalty,1 there are other considerations to take into account before choosing to convert. As with all important investment decisions, you should consult your financial and/or tax advisor before making a big move.
Points to Ponder Before Converting
Eligibility
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You must have a Modified Adjusted Gross Income of less than $100,000 (both single and joint filers).
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Married couples who file separately are not eligible to convert at all.
Ability to Pay Current Taxes
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To get the most benefit from a conversion, it is crucial that you can pay income taxes on your conversion without having to dip into the Traditional IRA.
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If you pay taxes from the Traditional IRA when you convert to a Roth, you will have to pay income taxes and possibly penalty taxes on any money you do not convert. In addition, you will lose the benefit of tax-sheltered compounding on that money.
Flexibility
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If you find out at year-end that your Modified AGI exceeds $100,000, or if you simply change your mind, you may "undo" your conversion without adverse tax consequences, as long as you undo it before your tax due date, typically April 15.
Current and Future Tax Brackets
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In general, if you expect your tax bracket to be lower in retirement, you might want to stick with a Traditional IRA.
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If you expect your tax bracket to increase or stay the same, a Roth IRA may be worth considering.
Years to Retirement
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The closer you are to tapping the money in your IRA, the less a conversion makes sense.
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If you have less than 12 years to go before you need the money, a Roth IRA conversion may not be for you.
1 Penalties will apply, however, to withdrawals of both principal and earnings from a conversion Roth IRA if taken within five taxable years of conversion, unless an exception applies.
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