How to decide whether to convert to a Roth IRA

Effective January 2010, the $100,000 modified adjusted gross income limit for converting a Traditional IRA to a Roth IRA has been removed permanently. This presents an opportunity for many to realize the benefits of a Roth IRA. Traditional IRA assets grow tax deferred until withdrawals are made. Any withdrawn amount is then taxed at your ordinary income tax rate plus any applicable early withdrawal penalty if the withdrawal is made before age 59-and-a-half.

Smart Business spoke with Donny Cole, CFP®, EA, financial planning analyst with Tegra Financial Partners, about the issues surrounding conversion.

What are the advantages of a Roth IRA?

With a Roth IRA, if you are age 59-and-a-half or older and have owned it for five or more years, distributions are tax-free. Also, there are no minimum required distributions for the Roth IRA account owner or for the spousal beneficiary. Nonspousal beneficiaries will be subject to minimum required distributions based on the beneficiary’s life expectancy. However, these minimum required distributions would be tax-free. To get the distributions over the nonspouse beneficiary’s life expectancy, make sure that the beneficiary is designated on the newly converted Roth IRA account. Otherwise, without a designated beneficiary, funds in the Roth IRA must be fully distributed within five years of the account owner’s death. The advantage of stretching out the tax-free distributions over your intended heir’s life expectancy is lost without a named beneficiary.

Is there a downside to converting?

There are some negatives to a Roth IRA conversion. Foremost is that the amount of the Traditional IRA converted is subject to income taxation in the tax year of conversion. But for year 2010 conversions only, the tax on conversion may be paid over the 2011 and 2012 tax years. The tax would be split 50 percent in 2011 and 50 percent in 2012. Additionally, large Traditional IRA accounts may be partially converted over the course of several years to reduce the amount of tax paid in any one year.

Be wary of other consequences that may result from the spike in income realized from converting a Traditional IRA to a Roth IRA. For example, qualifying for college education financial aid may be jeopardized. Taxable income is a primary determinant for institutions considering an applicant’s request for financial aid. Since your previous year’s taxable income will be factored into their decision process, you may need to coordinate the timing of a Roth IRA conversion.

Other tax benefits may be phased out based on taxable income. Consider the effect of losing the benefits as a result of the additional realized income from a Roth IRA conversion.

Bottom line, is it advantageous to pay the conversion tax now so that earnings from a Roth IRA may be withdrawn as tax-free income during retirement and leave any remaining Roth IRA assets to heirs who also could avoid taxes on the income?