If you have a Traditional, Rollover, or SEP-IRA, you may convert some or all of your existing IRA assets to a Roth IRA - as long as your Adjusted Gross Income (AGI) is $100,000 or less.¹ While a conversion requires you to include the taxable assets you're converting in current income, it enables you to avoid future federal taxes on any subsequent IRA earnings and withdrawals (provided certain conditions are met). This opportunity for federally tax-free growth and federally tax-free distributions can substantially increase the value of your retirement savings down the road.

Take a look at the difference in potential growth between a Traditional IRA and a Roth IRA. If you were to convert a $20,000 Traditional IRA to a Roth IRA, the chart below illustrates the difference between the two IRAs over 10-, 20-, and 30-years (assuming a 9% average rate of return).

This chart assumes a hypothetical Traditional IRA with a balance of $20,000 representing deductible contributions and tax-deferred earnings, which is converted to a Roth IRA. Both IRAs assume a 9% average annual effective rate of return, and a 28% federal tax bracket at the time of conversion and of distribution. The value of the Traditional IRA reflects tax-deferred growth over the specified period with the entire balance taxed at distribution. Plus, because the tax due at conversion is paid from funds outside the IRA, to make a valid comparison with the Roth IRA, the Traditional IRA value also includes the value of the tax that would have been paid for the conversion invested in a taxable investment, earning the same return; earnings on the taxable investment are taxed every year at 28% federal tax rate and the tax liability is deducted from the balance. The Roth IRA value includes the full $20,000 converted value which grows and is distributed tax-free at the end of the specified period. These values also assume there were no early withdrawal penalties upon distribution. This hypothetical example is for illustrative purposes only and does not represent the performance of any security, and returns will vary.

Factors to consider in making your conversion decision

Factor 1. Can you pay taxes on your converted IRA assets from a source other than the IRA itself?

To allow as much money as possible to grow tax-free, you should pay any applicable taxes on your IRA distribution out of your non-retirement savings. As long as you can pay the taxes from another source, you may benefit from a conversion.

If you must use some of your IRA assets to pay the taxes, you may be subject to an early withdrawal penalty on those assets. The resulting "cost" of converting could outweigh the benefit of tax-free growth.

If you find that converting all of your existing IRA assets to a Roth IRA presents too large a tax burden, consider converting just a portion which results in a tax payment you feel is manageable.

Factor 2. Can you leave your converted assets in your Roth IRA for at least five years?

The longer you expect your assets to remain in your Roth IRA, the more you can benefit from its tax-free growth potential. Plus, you may only benefit from federally tax-free distributions if you meet certain five-year aging and other qualified withdrawal requirements.

Factor 3. Will your tax rate be higher or lower when you use the money?

If you think your tax rate will be the same or higher than your current rate when you withdraw your money, it may make sense to pay the tax liability now - in exchange for the opportunity for tax-free growth and federally tax-free distributions in the future.

Factor 4. Have you made nondeductible IRA contributions?

If so, you'll only need to pay taxes on the earnings on those contributions when you take a distribution or convert. Taxes may also be due on any deductible or pre-tax contributions and earnings, as they must be included in your current income. Remember, however, that the IRS will consider the distribution to be prorata from deductible, nondeductible and pre-tax money, even if they are in separate IRAs.²

¹Converted amounts are not included in your AGI when determining eligibility. If you are married filing jointly or single, your AGI cannot exceed $100,000 in the year you convert. If you are married filing separately, you are not eligible to convert unless you have lived apart from your spouse for the entire taxable year.

² Refer to IRS form 8606 for complete information.

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