You may have already heard or read something about the Roth IRA Conversion. In 2010, the income limits on Roth IRA conversions disappear and now anyone can convert their Traditional IRA to a Roth IRA.
So, should you convert your Traditional IRA to a Roth IRA?
The answer is...it depends.
It depends on your individual circumstance. It is a fairly complex decision and below are just a few of the factors you should consider:
But first, a warning:
Regardless of your personal situation, financial institutions - banks, brokerage firms, fund companies, insurance companies - and their financial sales people - see the IRA conversion as an opportunity for a transaction which may mean additional revenue. Since the IRA conversion is a taxable event, the Internal Revenue Service may also profit from this transaction.
How do you decide if this is an appropriate strategy? Know your situation, understand your goals and update (or create) your personal financial plan. Then you (and your advisor) can determine if the IRA Conversion is the right strategy. While it may offer tremendous advantages to some, many individuals will likely pass due to the up-front tax costs and future tax-rate uncertainty.
Traditional IRA versus a Roth IRA
In simple terms, a Traditional IRA offers tax-deferred growth while a Roth IRA has the potential to provide tax-free growth. Assuming the same rates of return, tax-free is always better than tax-deferred. Traditional IRA owners must begin taking Required Minimum Distributions (RMD) starting at age 70 _. A big advantage of the Roth IRA is that owners do not have to take RMD's. Passing these assets to children income tax-free is a great way to pass on wealth.
Roth IRA Income Limitations
Tax-free compounding within the Roth IRA is such a good thing that Congress has established income limits on the Roth IRA. If your adjusted gross income (AGI) is more than $120,000 and $176,000 for single and joint tax filers, you can not make Roth IRA contributions.
Converting a Traditional IRA to a Roth IRA
It has always been possible to convert a Traditional IRA to a Roth IRA, but prior to 2010 your AGI had to be less than $100,000. Starting in 2010, the income limitation is eliminated. While you may not be able to make contributions directly to a Roth IRA due the income limitations, everyone can now take advantage of the Roth IRA Conversion.
Roth IRA Conversions are not free
When you convert Traditional IRA assets to a Roth IRA, you must pay taxes on the amount that is converted. If you have made both pre-tax and after-tax contributions to Traditional IRA's, you must pay tax on a "proportionate share" of your conversion. All of your Traditional IRA's are aggregated to determine the proportionate share. For example, if you have $100,000 in Traditional IRA's with $10,000 of after-tax contributions, 10% of the amount converted will be tax-free and 90% will be taxable. There is no minimum or maximum amount that can be converted and you can make a "partial" conversion.
The 2010 Roth IRA Conversion Advantage
The amount you convert in 2010 can be included as income in tax years 2011 and 2012. For example, if you convert $50,000 in 2010, $25,000 can be included as conversion income in 2011 and $25,000 in 2012.
When should I consider this strategy?
It's likely the Roth IRA conversion will mean increased taxable income. Use other non-retirement assets to pay the tax that will be due. If you have to use IRA assets to pay the tax, conversion may not be appropriate.
If you believe that your marginal tax rate will be higher in the future when you begin taking distributions from your IRA, consider converting. If your marginal tax rate will be the same or lower in the future, there may not be a significant advantage for you to convert. (Another warning: making predictions about future tax rates over the next 1 to 40 years is guesswork).
If your taxable income is projected to be very low in years 2010-2012, consider converting some of your Traditional IRA's in 2010 to take advantage of the lower marginal tax rates. Spreading the conversion income over two tax-years might also help keep your tax rates low.
When you convert to a Roth IRA, there is a five-year hold on qualified distributions. If you withdraw earnings from your converted Roth IRA held less than five-years, there could be a tax on earnings plus a 10% penalty tax depending upon your age.
If your estate is very large, passing assets to children via the Roth IRA can be advantageous.
Can I change my mind about a conversion?
If you change your mind about a conversion, you may undo it through a "recharacterization," which returns the assets to a traditional IRA. This can be done up to the due date of the return plus extensions. This might be helpful if you convert a Traditional IRA in January 2010, but the asset quickly drops in value. You can recharacterize the assets and then reconvert at a lower value to reduce your tax bill through the year.
Understand your current situation and objectives. Review a Roth IRA Conversion Analysis and see how this strategy fits into your cash flow, future income needs and estate planning goals. Consult with your tax advisor before making a conversion decision. Please call the Raskin Planning Group with questions.
Peter A. Raskin, CLU, ChFC, MSFS, CRPC is a registered representative of Lincoln Financial Advisors, a broker/dealer (SIPC) and registered investment advisor, 125 Summer Street, Suite 1400, Boston, MA 02110 (617)728-7433. Insurance offered through Lincoln affiliates and other fine companies.
By Peter A. Raskin