As most of you know, anyone regardless of income level can convert a traditional IRA to a Roth IRA. Whereas traditional IRAs are funded with pre-tax dollars and grow tax-free within the IRA, any distributions are fully taxable as ordinary income. In contrast, contributions to Roth IRAs are not deductible; however, the assets in a Roth grow on a tax-free basis and the distributions are tax-free to the recipient.
As to whether you should take advantage of the opportunity to convert is a decision that has to take into account that it is not a tax-free ride. The conversion is a fully taxable event. And to achieve the best financial results, the attending tax should be paid from non-IRA assets. Clearly, this conversion can be expensive.
If there is a silver lining in the drop in the stock market from a high of almost 13,000 in the Dow to about 11,000 where it is as of this writing—nearly 20% lower—it is that a Roth conversion is going to cost you a lot less. The cost of a $400,000 conversion for someone in the 35% bracket would be $140,000, in contrast to $175,000 when the IRA was worth $500,000 at the market high: a $35,000 savings.
To further ameliorate the tax cost, consider that your 2011 charitable contributions will also offset the tax on the conversion. For example, a $50,000 charitable contribution will lower your tax by $17,500.
Another approach to consider to further reduce the tax impact is to accelerate future charitable contributions that you would ordinarily make over the next five or ten years into this year.
For example, $250,000 worth of charitable contributions that you would make over the next five or ten years would reduce your current tax liability for the conversion by another $87,500 from the $140,000 that you would otherwise owe.
It’s best to use appreciated property to fund your charitable contributions as this will give you the added benefit of avoiding the capital-gain tax on the appreciation.
Considering the historically low interest-rate environment that we currently have, borrowing to cover the cost of conversion can make sense as it would entail little cost.