|
|
By Terence Myers and Dorinda DeScherer, Editorial Resource Group, Inc.
To Convert or Not Convert—That is the Question
"Should I convert my traditional IRA into a Roth IRA?" Because of a tax law change, people who were not eligible to convert in the past are now able to do so. And even those who have been conversion-eligible in the past but never did anything may now be interested in a conversion simply because of the spotlight that the tax law has thrown on conversions. As of January 1, 2010, the income requirement for conversions (or rollovers) of traditional IRAs to Roth IRAs has been eliminated. Under prior rules, a person could convert a traditional IRA into a Roth IRA only if modified adjusted gross income was $100,000 or less. Now a conversion is permitted regardless of modified AGI.
For conversions to a Roth IRA in 2010 only, you will have the option of reporting the full taxable portion of the conversion (which will generally be 100% unless nondeductible IRA contributions have been made in the past) in gross income for 2010, or reporting half in 2011 and half in 2012. All future distributions from the Roth IRA will be excludable from income if made (1) after 5 years (measured from January 1 of the year of the conversion and ending on the last day of the fifth year) and (2) on or after you reach age 59½. What's more, amounts withdrawn early will be treated as coming first from funds on which tax has already been paid. So no tax will be due unless you dip into earnings on the account prematurely.
Does a Conversion Make Sense?
Of course just because the tax law allows a person to convert a traditional IRA into a Roth IRA does not mean it's necessarily a good idea. A conversion is a trade-off: You are accelerating the tax on prior contributions and earnings to avoid tax on future earnings. Whether that makes sense depends on your individual situation. A good place to begin analyzing your situation is to look at the answers to key questions:
• |
How old are you? If you are at or near retirement and expect to begin withdrawing funds in the near future, the benefit of a conversion is reduced. The accumulated earnings and contributions, which will be currently taxed, will be large in proportion to the future untaxed earnings in the Roth IRA.
 |
• |
How are the IRA funds invested? If the traditional IRA funds are invested in stocks and mutual funds, the current value may be significantly lower than their value in the past or in the future, reducing the tax on the conversion. In other words, if a conversion is ever to be done, the economic downturn may make this the ideal time to make a "bargain" conversion. On the other hand, this would not be the case if the funds are invested in CDs or the like.
 |
• |
How much is being converted? If the amount converted is large, the conversion may push you into a higher tax bracket. The increased adjusted gross income may also have a ripple effect on other items, such as the inclusion of Social Security benefits in income and eligibility for various deductions and credits. That means that the tax on the accumulated contributions and earnings will be higher than if the funds had been left in the traditional IRA and withdrawn over a period of years. However, there is nothing that requires the entire traditional IRA to be converted in one year. For example, amounts could be withdrawn from a traditional IRA in dribs and drabs over a period of years and placed in a Roth IRA. This would spread out the additional conversion income over the same time frame as periodic withdrawals from the traditional IRA, thus avoiding a higher tax bracket.
 |
• |
Do you need the IRA funds during retirement? Some people may not need the IRA funds during retirement; they would like to pass on most or all of the IRA funds to their children. In this case, a conversion is more attractive. The owner of a traditional IRA must begin taking annual minimum withdrawals once he or she reaches age 70½. There is no such requirement for Roth IRAs. The IRA funds can continue to grow and compound tax-free during the owner's life, and the heirs can withdraw the funds tax-free after his or her death. The accumulated IRA funds will, however, be subject to estate tax (assuming the estate tax is reinstated).
 |
• |
How will the conversion tax be paid? If you have ample funds outside of the IRA to pay the tax on the conversion, fine. But if you must use a portion of the IRA funds to pay the tax, this will reduce the amount invested in the Roth IRA. That, in turn, will reduce the amount benefiting from the tax-free growth and the income exclusion for the Roth IRA.
 |
• |
When will the conversion tax be paid? A person who wants to pay the conversion tax with outside funds, but needs more time to get them together, can opt to defer the tax to 2011 and 2012 (see above). However, keep in mind that the current low income tax rates are scheduled to expire at the end of 2010. Unless Congress votes to extend the current rates, they will return to their higher pre-2001 levels. That would make a deferral of the tax to 2011 and 2012 much less attractive. |
|
