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Should I do a Roth IRA Conversion with My Self Directed IRA?

The decision of whether to convert a Traditional IRA to a Roth IRA is a decision most of us wrestle with at some point. The advantage of making a Roth IRA conversion is that once the individual turns 59/1/2 and the Roth IRA account has been opened a least five years, all Roth IRA funds can be taken as a distribution tax-free. Whereas, in the case of a Traditional IRA, when a distribution is taken, the amount of the distribution is subject to tax and potentially a 10% penalty if the IRA holder is under the age of 591/2. There is no right or wrong answer to whether someone should elect to do a Roth conversion with their Self Directed IRA. The decision is typically based on a number of factors specific to the individual making the decision. Of course, an individual electing to do a Roth conversion with their Self Directed IRA, would have to pay income tax on the amount of the conversion. The tax would be due the following year and must be reported on the individual’s federal income tax return. The IRA custodian would issue a 1099-R to the IRS and the IRA holder indicating the IRA amount subject to the Roth conversion.

When determining whether to make a Roth IRA conversion with a Self Directed IRA, it’s important to consider the following factors:

  1. Can you pay the tax due. This is probably the most important factor since if you can’t afford to pay the tax due than making the Roth IRA election is not really an option. Also, using IRA funds to pay the tax may not be a wise choice since you are taking tax-deferred funds to pay the tax.
  2. Your age: The younger you are, the more attractive making a Roth IRA conversion is. This is because the younger you are the more potential tax-free growth that exists in your IRA. Whereas, the closer you are to 70, the potential tax-free growth in the account will not be as great.
  3. Projected Returns. If you believe that the investments you will be making with your Self Directed IRA will generate high returns versus a more conservative investment approach, then making a Roth conversion may make more sense since the future tax-free growth may allow you to recap the tax paid on the conversion much quicker.
  4. Need for the IRA Funds. If you believe you will need to use the IRA funds to live on when you retire and you expect to have a reduced income tax rate at that time, then making a Roth IRA conversion may not be as attractive since your income tax rate may be lower than it is now when you are required to start taking IRA distributions.
  5. Anticipated Federal Income Tax Rates. If you believe that the federal income tax rates will increase in the near future, then making a Roth IRA conversion is more attractive since you will be paying tax on the Roth IRA conversion at a lower rate than you would be if you paid tax on the distributions in the future.
  6. Size of IRA and Age. The smaller the IRA and younger the IRA holder, the more attractive a Roth IRA conversion is since the tax bite will be much easier to swallow.
  7. Appetite for Risk. Paying tax up-front in order to preserve a tax-free return on investment is always a risky proposition since one can never fully guarantee an investment’s success. Everyone remembers Enron and the 2008 Wall Street crisis, how would you feel if you did a Roth conversion and purchased Enron stock and then were left with nothing. The Roth conversion risk is that you are paying tax up-front for a potential for tax-free growth, but no one can ever guarantee how an investment will turn out.

In sum, making a Roth IRA conversion is a very important decision that should be given careful consideration. As references above, there are a number of important factors that must be considered before determining whether or not to make the Roth IRA conversion. Unfortunately, there is no right or wrong answers – just a lot of second guessing.

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Posted in Self-Directed IRA

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