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 Any withdrawn amount is then taxed at your ordinary income tax rate plus any applicable early withdrawal penalty if the withdrawal is made before age 59-and-a-half.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?
What are some other considerations?
With the stock market decline over the last year, 2010 may be a good time to consider a Roth IRA conversion. By taking advantage of current depressed account values, the conversion tax will be less now than when the economic conditions improve and account values recover. Some other factors to consider are:
- When will the funds be needed to withdraw for retirement income? The more time you have, the more beneficial prepaying the taxes at conversion will be. This is because there will be more time to possibly grow and compound growth tax-free.
- Do you have sufficient funds from sources other than your IRA to pay the tax on converting to a Roth IRA?
- What is your expected income tax rate during retirement? If you expect rates to be lower in retirement, converting to a Roth IRA may not be advantageous. You would be paying higher taxes on the conversion now while later withdrawals from a Traditional IRA would be paid at lower tax rates. If you expect your income tax rate to be higher during retirement, converting to a Roth IRA makes more sense. In this case, the conversion taxes would be paid now at a lower rate while later withdrawals from a Traditional IRA would be paid at a higher rate.
- Is it important for you to leave a tax-free inheritance for your heirs?
- What if you later realize that, after a Roth IRA conversion, it was not such a great idea for your situation after all? The Roth IRA recharacterization rule allows you to reverse the conversion as if it never happened up to the extended due date (Oct. 15) following the year of conversion.
In any case, the decision to convert an existing Traditional IRA to a Roth IRA is unique for each individual. To find out if this might be good for you, contact your financial or tax adviser.
Donny Cole, CFP®, EA, is a financial planning analyst with Tegra Financial Partners, a subsidiary of Habif, Arogeti & Wynne, LLP. Reach him at firstname.lastname@example.org or (770) 353-5338.