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To Convert Or Not To Convert... Your 401k/IRA Vs Roth IRA

Should I convert my 401k/Traditional IRA into a Roth? When is it worthwhile? There is a very easy way to answer this question assuming you do not take into account the fact that many company sponsored 401k's are more limited in investment choice. If we just compare a Traditional IRA vs a Roth IRA, we have the same effect of pre tax vs after tax accounts to see which is better for you.

In 2010, the government allowed for the rollovers of Traditional IRAs to Roth IRAs and to split the tax payments into 2 payments payable in 2011 and 2012. This was done to generate tax revenues that the government needed. It was both good and bad. Good for us, in that longer term we gain more savings/investments, but in the shorter term, the government received more taxes, but loses out on future taxes.

Now that the time has passed for that special rule, it still may be worthwhile to convert your IRAs. It mainly boils down to a factor of, do you think your current tax rate or your future tax rate (when you will be taking money out of your retirement accounts) will be higher. Assuming a same rate of return, if your current tax bracket is 35% and your retirement tax bracket is 35% and during the entire holding time the return is 10%, both accounts will net the same net dollar return for you. Now if you think your current tax rate is higher than your future tax rate, a Traditional IRA may be better for you as the immediate tax reduction is more beneficial. If you think your future/retirement tax rate will be equal or higher, then a Roth IRA may be for you.

Here's a chart showing contributions with a 25% tax rate, 10% annual returns for 10 years.

As you can see, the traditional seems to be the better choice until taxes are taken out and you end up at the same exact place. Please note, to take into account the taxes, we assume that you only have 5000 to put toward savings. If you go with the ROTH option, your taxable income will be higher so your contribution will be lower.

One item to keep in mind, is that a Roth IRA does not have required minimum distributions (RMDs). With traditional IRAs, you are required to take an RMD by the April 1st after you turn age 70 1/2. With Roth IRAs there is no restriction in your lifetime, but your heirs will have your RMDs. But that is a post for another time.