2010 is in full swing, and by now I’m sure you’ve heard something about the Roth IRA conversion event of 2010. All the brokerage firms are making a stir over it and maybe you’re scratching your head and wondering if its another bandwagon for you to jump on. Before you make the leap, let’s look at the basics of the conversion and then some of the tax rules if you decide to convert.
What’s so special about 2010? Previously, investors who wanted to convert to a Roth IRA and had an AGI above $100,000 couldn’t do so before their income was too high. Starting in 2010, this restriction is lifted, allowing boomers and investors at any income level to move assets in a traditional IRA over to a Roth IRA.
To make the deal even sweeter, the IRS is allowing those who convert in 2010 to spread the federal income tax owed on the converted sum over two years, a special rule to help lessen the tax blow of having to pay it all in one year.
Splitting the Tax Bill
The tax rules on converting to a Roth IRA 2010 are a little tricky, but here’s the gist. If you elect to defer the tax payment over the 2 years (this is default choice), whatever amount you convert in 2010 you’ll have to pay no income tax for this tax year. The remaining will be split 50/50 over the 2011 and 2012 tax years and added as income for those years (not based on 2010 income levels). Essentially, you won’t be making the last tax payment until 2013 when you file your taxes for 2012.
Does it Make Sense to Convert to a Roth IRA?
The answer to this question will differ for every investor, depending on a number of factors including the amount of time you plan to leave the money invested, your estate planning objectives and your willingness to pay the federal income tax bill that a conversion will trigger. Here is a look at the potential benefits and drawbacks of converting.
Benefits of Converting to a Roth IRA
Tax free gift to your heirs.
Since required minimum distributions (RMDs) do not apply for Roth IRAs as they do for traditional IRAs, investors who do not need the money may leave it invested as long as they choose, which may result in a larger balance for heirs. After your death, you beneficiaries are required to take distributions, although they are not required to pay taxes on the distributions. FYI, there are different rules apply for spouses as opposed to children and other non-spousal beneficiaries.
Tax-free withdrawals on qualified distributions.
After you’ve converted, you have five years to wait until you can withdrawal money completely tax free. If you are already over 59 1/2, you’ll have immediate access to the conversion amount, but still have to wait five years to tap any of the earnings with no consequence.
Downsides of Converting- Tax Implications
Pay the tax with outside monies.
Investors who convert assets from a traditional IRA to a Roth IRA are required to pay taxes on the amount that is rolled over. The full amount of the conversion is usually taxable at ordinary income tax rates. If you have a nondeductible traditional IRA (i.e., your contributions did not qualify for a tax deduction because your income was not within the parameters established by the IRS), investment earnings will be taxed but the amount of your contributions will not. The conversion will not trigger the 10% penalty for early withdrawals.
Aggregate of all Your IRA’s.
If you have a mixture of pre-tax and post-tax (nondeductible IRA’s), the IRS will treat them all as “one” when you go to convert. If, for example, you just wanted to convert just your non-deductible IRA’s so that you can minimize the taxes on the conversion, you’ll have to pay a pro-rata tax.
Pro-Rata Conversion Tax Example
For example, suppose you have $15,000 in a non-deductible IRA that hasn’t generated any earnings and own deductible IRAs worth $150,000. If you converted $15,000 to a Roth, 90% of the conversion would be taxable, because 90% of your combined IRAs were funded with deductible contributions.
Don’t Forget Required Minimum Distributions
Seniors that have already reached 70 1/2, may try to use the Roth IRA conversion as away to avoid having to take out their RMD’s for the current year. This is not the case. You will first have to take out the RMD amount, pay the tax, then you’ll be able to convert the rest.
If you mistakenly convert the entire amount, it could result in an excess contribution and you will be faced with the 6% excise penalty for each year that you leave it in the Roth account. Ouch!
Is the Roth IRA Conversion Right For You?
If you are still on the fence whether converting your traditional IRA or 401k into a Roth IRA is right for you, here are some further considerations:
A conversion may make more sense if retirement is further away.
The longer your earnings can grow, the more time you have to compensate for the associated tax bill.
Your expected tax rate will be the biggest determinant.
If you expect to be in a lower tax bracket during retirement, sticking with a traditional IRA could be the best option because your RMDs during retirement will be taxed at a correspondingly lower rate than amounts converted today. On the other hand, if you anticipate being in a higher tax bracket, the ability to take tax-free distributions from a Roth IRA could be an attractive benefit.
There is no easy answer to the question: “Should I convert my traditional IRA to a Roth IRA?” Double check with your tax professional before you make the move. If you want to do some number crunching on your own, check out all these Roth IRA conversion calculators.