Roth IRA- To Convert or Not? Part I

Roth IRAs have a couple of significant advantages over traditional IRAs. First, while contributions to a Roth are not tax deductible, withdrawals during retirement are tax free versus taxable withdrawals from traditional IRAs. Second, unlike traditional IRAs, Roth IRAs do not require that you take minimum withdrawals beginning at age 70 ½. Unfortunately, prior tax law has prevented high income earners from accessing Roth IRA plans…until now. Let’s take a quick look at the rules and how they have changed as well as some strategies you can use to your advantage: 

  • The ability to contribute to a Roth IRA is phased out for joint tax filers whose modified adjusted gross income (MAGI) in 2009 was between $166,000 and $176,000 ($167,000 and $177,000 for 2010) or individual filers with MAGI between $105,000 and $120,000.
  • If you wanted to convert an existing IRA to a Roth in 2009, you could do so only if your MAGI was less than $100,000.   This limitation has been removed for 2010, creating a potential opportunity for roughly 16 million Americans.
  • If you do convert your traditional IRA to a Roth, you must report as income all of the proceeds less any non-deductible contributions. The law allows you to pay the taxes either in 2010 or you can delay the reporting and show half of the proceeds in 2011 and half in 2012 and pay taxes based on the tax rates in effect in those years. Note that tax rates are set to rise in 2011 so any decision to postpone reporting should be done with the advice of your tax advisor. 
  • You can do an ‘in-kind’ conversion, meaning you’re not required to sell securities; rather you can simply transfer securities from your IRA account to your Roth account.
So now that everyone is eligible to play the conversion game, should you? The answer will be dependant upon your personal facts but here are some guidelines to get you started:
  • If you are considering converting part or all of your IRA to a Roth, you’ll want to be certain that you can pay the taxes due from funds outside your IRA account otherwise you’ll basically defeat the purpose. If you were to pay taxes from the IRA account, that withdrawal would be reportable as ordinary income plus if you are under age 59 ½, you’d also be subject to a federal 10% penalty.
  • The more time you have before you’ll need to tap your retirement accounts, the more advantageous is the conversion to a Roth. This is because money has more time to grow tax free and offset the upfront taxes you paid upon conversion.
  • If you believe that your tax bracket when you withdraw funds during retirement is likely to be much higher than now, the more advantageous it is to convert now. 
  • If you believe that there is a good chance you’ll not need your IRA account for retirement income, converting to a Roth will both avoid Required Minimum Distributions (RMDs) beginning at age 70 ½ and allow your heirs to take tax free withdrawals regardless of their tax bracket.
Next week, I’ll discuss little-known strategies that you can use to take advantage of Roth conversions.