Low investment balances, relaxed income limits make it worthy of consideration.
By Christine Benz | 08-27-09 | 06:00 AM | Email Article

Who Should Think Twice
Clearly, an IRA conversion can make sense for individuals in many different situations. However, there are a few situations in which the conversion will be less beneficial. One of the key ones will be if you don't have the money in other assets to pay the tax associated with the conversion. If you're younger than 59 1/2 and your only option is to use part of the traditional IRA assets to pay the tax, you'll pay a 10% early-distribution penalty on any assets you don't roll directly into the Roth. Plus, you'll have less money at work for your retirement.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

In addition, those who know they'll be in a significantly lower tax bracket in retirement should think twice about converting. Also be careful if it looks like your conversion will push you into a higher tax bracket in the year in which you convert. The risk is that you could disqualify yourself for tax benefits, such as credits and deductions, that you would otherwise be eligible for.

In all of the above situations, though, you should be aware that you needn't convert all of your IRA in one fell swoop. Partial conversions are also permissible. However, you can't pick and choose which IRA assets to convert--for example, you can't convert all of your nondeductible IRAs and leave your deductible IRAs intact, although that would be advantageous. Instead, each dollar you convert will receive exactly he same tax treatment based on your aggregate IRA's breakdown between deductible contributions/ investment earnings and nondeductible contributions.

For example, say you have $100,000 in an IRA that's composed of $30,000 in deductible contributions, $10,000 in investment earnings, and $60,000 in nondeductible contributions. In that case, 40% of every amount that you convert would be taxable upon conversion (that 40% encompasses deductible contributions and investment earnings), whereas you wouldn't owe taxes on 60% of your conversion (the percentage of your IRA portfolio represented by nondeductible contributions). Each subsequent conversion that you do would receive the same 40% taxable/60% nontaxable treatment.

If you determine you want to move forward with a conversion, it pays to double-check with a financial advisor or tax specialist to make sure you're thinking through all of the variables. And when you do convert, make sure you mind your Ps and Qs. IRS Publication 590 (Individual Retirement Arrangements) includes all of the nitty gritty details. Your investment provider should be able to walk you through the forms you need to fill out for the conversion; some investment providers now allow you to make the conversion using online tools.

Also know that if you convert your IRA from a traditional to a Roth, you needn't change your investments--you're changing the tax treatment of those investments, not the investments themselves. Finally, be mindful of the deadlines related to conversions. Whereas you have until April 15 to make an IRA contribution, the conversion will need to be done by December 31 to count for that tax year.

A version of this article appeared on Morningstar.com on Feb. 12, 2009.



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