For the best site that I’ve found to the Traditional-to-Roth IRA conversion process (and more clear than the IRS instructions), see the Fairmark guide. Reading through it, you can see there are a ton of variables to consider, including evaluating your current situation and predicting future legislation. Here’s a summary of my decision process after reading the guide:
Am I Allowed To Convert?
My main concern was the income limits. No matter if you are single or married, your total combined modified adjusted gross income (MAGI) cannot be over $100,000. The definition of MAGI is pretty confusing – either read Pub 590 or better yet Fairmark again for the details. But one way to lower your MAGI is to make contributions to your employer’s retirement plan (401k, 403b). Making more pre-tax contributions to enable you to convert pre-tax contributions to post-tax contributions may seem a bit paradoxical, but I just see it all as increasing your retirement savings.
Note that the income limits are scheduled to be removed in 2010.
What Types Of IRAs Can I Convert?
You can convert both a SEP-IRA or Traditional IRA into a Roth IRA. You can also convert an old 401k/403b/457 plan from your employer to a Traditional IRA, and then convert that to a Roth IRA if you satisfy all of the conditions. My current Traditional IRA is a mishmash of all three of these – an old Rollover 401k, straight Traditional IRA contributions, and a SEP-IRA.
Should I Convert?
A big part of this question relates to whether you like the idea of being taxed now and not later (Roth), or taxed later but not now (Traditional). This involves comparing your current marginal tax rate and your estimated tax rate in retirement. For some of us this involves looking 30+ years in the future. Who knows what the tax brackets will be then. Most people tend to guess higher. But it’s also a possibility that Roth IRA distributions may also be taxed for those having certain income levels. Who knows.
You can also “fit more money” into a converted Roth IRA. For example, by turning $1,000 of pre-tax money into $1,000 of already-taxed money, you pay more out-of-pocket now but will save yourself that huge tax bite in the end. Just be sure you have the money to cover the conversion.
My opinion is that our current tax bracket of 25% is historically not that high, and it is more likely to be higher during retirement than lower. On the other hand, we also would like to have some more cash on hand for a house down payment.
How Much Should I Try To Convert?
You can actually do a partial conversion if you like. One reason to do so is that the amount of the rollover will be considered income and it may push you into the next marginal tax bracket. You may also lose some tax credits that are sensitive to income. That wasn’t an issue for me, so I went ahead and converted over the entire amount.
How To Pay For The Conversion
As previously mentioned, you should really be able to cover the tax from the conversion using existing funds from outside the IRA.
State Income Taxes
You may want to consider specific state tax consequences as well.
After some swaying back and forth, I went ahead and sent in the paperwork by the year-end deadline to Vanguard in order to start the conversion. This means owing an extra several thousand dollars in taxes this year. I also considered waiting until 2010, but by then I would likely be in a higher tax bracket than now. I am still able to reverse the conversion until as late as October 2007 without paying taxes or penalties if I change my mind.