Consider a Roth conversion only if you answer yes to these questions:
Is your personal tax rate likely to rise in retirement?
For many people the answer is no. If you're in your late 50s and earn a substantial income, you're in a high tax bracket now, but your rate may decline after you stop working. You don't want to pay hefty taxes now on money you can withdraw less expensively later.
Do you have cash outside the IRA to pay the taxes you'd owe?
You defeat your purpose if you steal from your retirement savings to pay the taxes. Let's say you pay the tax with $25,000 from a $100,000 IRA. That leaves only $75,000 to earn tax-free income in the Roth.
Have you taken care of higher financial priorities?
Consider your entire situation. If your spouse was just laid off or you're still paying tuition bills, don't spend your cash on a Roth conversion. If you're under 59 1/2, you'll pay a 10 percent penalty for withdrawing converted Roth funds within five years of setting up the account.
Crunching the Numbers
Many free online calculators aim to help you gauge the wisdom of a conversion. (One of the easiest to understand is at moneychimp.com.) But you really need a professional's help to make this decision. Online calculators give you at best a rough idea of whether you would come out ahead. At worst they can mislead you, because of their built-in assumptions about essential variables—future rates of inflation, taxation, investment return—and wild cards such as whether you'd invest the tax money you save by not converting, whether you'll make postconversion contributions to the Roth IRA, and whether you'll withdraw your nest egg in a lump sum or (much more likely) in smaller pieces each year.
Yes, it can all be head-spinning, and no online calculator can address individual costs and benefits. The extra income you must declare when moving funds from a traditional IRA to a Roth could temporarily put you in a higher tax bracket, or make you ineligible for tax breaks that phase out as income rises. If you're a Medicare recipient, it could temporarily increase your Medicare Part B premium. Still, the prospect of lowering your future tax bill with a Roth can make these short-term costs worthwhile. And, notes Barry C. Picker, a Brooklyn, New York, tax accountant and leading IRA expert, Roth IRA withdrawals aren't included in the income numbers the IRS uses to determine whether your Social Security check is taxable.
The bottom line: If you're seriously considering a conversion, consult with a certified financial planner or tax accountant. Expect to pay $500 to $2,000, depending on where you live and the size of the firm you use. And don't be dazzled by the 2010 tax break. Despite financial pros' enthusiasm, this isn't your last chance for a Roth conversion. In fact, Picker predicts, many savers will find a gradual approach works best. "For many middle-class people in their 50s, I think it makes more sense to do a series of small annual conversions," he says, to minimize the immediate tax burden. "That's a more affordable way to achieve a meaningful tax-free account in retirement."
Contributing editor Lynn Brenner wrote about getting the most from Social Security in the September-October issue.