Should you convert to a Roth IRA?
There's a lot of buzz these days about changes to the tax law concerning converting to a Roth IRA. Simply stated, beginning January 1, 2010,
many investors will be eligible for the first time to convert traditionallRAs to Roth IRAs, which could allow them to protect some or all their
retirement savings from taxes in later years when they retire.
On the surface this may seem like a good deal, and for some investors it will be, but there are several key aspects of this change that you
should consider before deciding whether taking advantage of the new law is the right thing for you to do. Most importantly, you should seek
the advice of both your financial professional and tax advisor before you take any action regarding any of your retirement plan assets.
What are the changes to the rules?
According to the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005:
- Effective January 1, 2010, the IRS will remove income limits for converting
traditional, rollover, SIMPLE, and SEP-IRAs to Roth IRAs. Starting in January,
households with incomes of $100,000 or more (or married couples filing
separate tax returns) will be allowed to convert to a Roth IRA for the first time.
- Investors who choose to convert in 2010 have the option to spread the taxable
income that results from the conversion equally between 2011 and 2012 or to
recognize all of the income in 2010. This option to spread the taxable income is
only in effect for 2010 conversions. Investors who convert to a Roth IRA in 2011
and beyond will be required to recognize all of the income in the year in which
the conversion occurs.
It is important to note that there will still be income limits for contributing to a Roth
IRA in 2010 and beyond.
What are the benefits of converting to a Roth IRA?
If you haven't had a Roth IRA before, you may not be familiar with its benefits. To
understand Roth IRAs, let's start with traditionallRAs.
With traditionallRAs, you may be able to make pre-tax contributions. Any pretax
contributions, as well as all their earnings are not taxed until you begin to
make withdrawals. At the time such amounts are withdrawn, they will be taxed as
ordinary income. Further, you must begin taking money out of your traditional IRAs
at age 70 1/2, also known as required minimum distributions.
When you contribute (or convert) to a Roth IRA, you can only invest with money that
has already been taxed, so the amounts contributed will not be taxed when they are
withdrawn. In addition, if certain conditions are satisfied, earnings also will not be
taxed on withdrawal. Further, there is no minimum distribution requirement at age
70 1/2, so your investment can continue to grow tax-free throughout your lifetime.
Sounds good! So what's the catch?
The catch is all about the tax consequences. If you convert a traditional IRA to
a Roth IRA, you wi II have to pay taxes on the pre-tax amount you convert. For
example, if you convert $100,000 from a traditional IRA to a Roth IRA and are in the
28% tax bracket, you could owe $28,000.
That is why it's very important that you determine the amount of tax you would
owe and have a plan as to when and how you will pay it. Because your tax liability
could be significant, it is important for you to work with your tax advisor before
deciding to convert to a Roth IRA.
Where would the money to pay the taxes come from?
If you have access to cash in another account, that may be the best place to access
money to pay your tax liability.
If you think you'd use money from your traditional IRA to pay the taxes, think again.
Reducing your retirement savings just to switch to a Roth IRA may not be the wisest
move. You'd actually be defeating the purpose of the Roth IRA, which is to generate
future tax-free earnings. And if you're under age S9 V2, you could be subject to a
10% IRS penalty on the money you pull out of your IRA to cover the taxes.
Should you convert all of your traditional IRA to a Roth IRA?
Maybe, maybe not. It's complicated. Again it depends on several things, like
whether the amount of income from the conversion would push you into another
tax bracket, your age, when you plan to begin withdrawals, what you think tax
rates are going to be in the future, and so on.
Remember if you convert to a Roth IRA in 2010, you have the one-time choice of
spreading the taxable income equally between 2011 and 2012 or recognizing all of
it in 2010. And because tax rates are projected to rise in 2011, this adds additional
complexity to your decision.
More than likely your financial professional and tax advisor both have tools and
calculators to help guide you through the decision process.
Is there a timeframe that the Roth IRA must be in effect before withdrawals can begin?
Yes, keep "five years and 59 V," in mind and consider the amount you converted
and the earnings since you converted separately.
First, you can withdraw the amount you convert tax-free at any time. But if you are
less than 59 V, and you've held the converted Roth IRA less than five years, you'll
pay a 10% IRS penalty. Secondly, you can withdraw the earnings tax-free and
penalty-free only if you're 59 ';' or older and you've had the Roth IRA for at least
five years.
Bottom line: reconsider converting to a Roth IRA if you think you'll need to
withdraw the money within five years.
Can a Roth IRA be left to a beneficiary?
Absolutely. In fact, you never have to withdraw money from a Roth IRA as you
do with a traditional IRA because a Roth IRA is not subject to required minimum
distributions. This means a beneficiary could inherit the entire balance. What's
more, the beneficiary could withdraw the original amount of the conversion taxfree.
The earnings would also be tax-free as long as the Roth IRA had been in effect
for at least five years.
Isn't converting to a Roth IRA like an IRA rollover?
No. Don't confuse the process of converting to a Roth IRA with moving your 401lkl
or other retirement plan to a traditional rollover IRA. With a traditional rollover
IRA, you invest a distribution received from a qualified retirement savings plan
directly into a traditional rollover IRA and avoid taxes and penalties at the time of
the rollover. A rollover from a qualified retirement plan now also may be made to a
Roth IRA, in which event the rollover will be taxed in the same general manner as a
conversion from a traditional IRA to a Roth IRA.
Want more information about converting to a Roth IRA?
It is important to note that the question of whether to convert to a Roth IRA is a tax
question, not an investment question. If you choose to convert, in all likelihood you
will be able to maintain the same portfolio you have in your traditional IRA. In any
event, do not make this decision on your own. Call your financial professional and
tax advisor before making any changes to your retirement savings plans.
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