To Convert, or Not to Convert: That is the Question for IRA Owners

The Roth IRA can be an extremely powerful vehicle for retirement savings.  Although contributions to a Roth IRA do not provide a current tax deduction, future withdrawals (once you reach the age of 59 and a half) are totally tax-free.  For high net worth taxpayers, whose income is not anticipated to decline substantially after retirement, the benefit of a current deduction can be far outweighed by the tax-free withdrawal of the presumably appreciated investments in the future.

More Benefits of the Roth IRA

Furthermore, the lack of an annual required minimum distribution from the Roth IRA can provide for additional tax-free growth.  While traditional IRAs mandate that the account owner must make annual withdrawals beginning after they reach age 70 and a half, Roth IRA owners and inheriting spouses are not required to make any lifetime distributions.  If assets and income outside of the IRA are sufficient to cover the expenses of the retiree, the Roth IRA can be left untouched allowing the assets to continue to appreciate tax-free.  

Unfortunately, the Roth IRA has not traditionally been available for all individuals.  The ability to make contributions to a Roth phases out for taxpayers with higher incomes.  In 2010, the ability to make a Roth contribution evaporates with modified adjusted gross income between $105,000 and $120,000 for single filers and between $167,000 and $177,000 for joint filers.  Likewise, in the past the ability to convert a traditional IRA to a Roth was only available for taxpayers with modified adjusted gross income below $100,000.

Lifting Limits on IRA Conversions

Beginning in 2010, the $100,000 income limitation on conversions of a traditional IRA to a Roth IRA has been abolished.  This means that all taxpayers can now elect to currently pay tax on their IRA account balance in exchange for the ability to take future distributions of contributions and earnings totally tax-free. 

The recent law change provides an additional benefit for taxpayers who elect to convert in 2010. If you convert a traditional IRA to a Roth during 2010, any taxable income from the conversion is deferred and is recognized ratably in the 2011 and 2012 tax years.

Conversion Factors: What You Need to Know About Converting Your IRA

If you are considering converting your traditional IRA to a ROTH IRA, here are some basic questions to ask before making your decision.

1. Can you pay the tax on the conversion without using funds from your IRA?  When you convert, you will have to pay tax on any earnings and pretax contributions.  If you must use funds from the IRA account to pay the tax, you will face an additional 10% penalty if you are under the age of 59 and a half.  You will also lose the opportunity for tax-free appreciation on those funds.

2. What will the impact of the conversion be on other tax benefits?  The conversion income could raise your marginal tax bracket, phase you out of the child tax credit and the higher education tax credit, as well as cause the limitation of itemized deductions and personal and dependent exemptions.

3. How much time do you have until retirement or until you need the IRA funds?  Typically, the younger you are the more you can benefit from conversion.  The longer your new IRA investments can appreciate tax-free, the more time they have to recoup the taxes paid on the conversion.  For older taxpayers, conversion can still be advantageous if your goal is to avoid mandatory withdrawals from your IRA.

4. When should I make the conversion?  Conversions in 2010 will result in a deferral of the taxable income to 2011 and 2012.  It is generally advantageous to defer the recognition of income; however, your personal income should be considered before making a decision about timing of the conversion and election out of potential deferral.  Due to the current economic situation, many taxpayers, particularly business owners, are reporting significantly lower income than average.  This may present a tax planning opportunity.  It is also important to keep in mind that after 2010, the highest marginal income tax brackets will be increasing as the Bush era tax cuts sunset.

Like most investment and financial decisions, the question of whether or not to convert a traditional IRA to a Roth IRA is fraught with complications and is highly subjective based on the individual taxpayer’s situation and goals.  Careful planning and projection of the dollars and cents impact with a competent tax or financial advisor should be completed before a decision is made.