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Ready to convert to a Roth IRA?

June 19, 2009

Even if converting your traditional IRA to a Roth IRA isn’t an option for you today, it will be next year. That’s because starting in 2010 the income and marital status restrictions that might otherwise restrict your ability to make that conversion will no longer apply.

Under current law, an individual with a modified adjusted gross income (MAGI) of more than $100,000 (not counting the conversion amount) isn’t allowed to convert a traditional IRA to a Roth IRA. Married individuals filing separate returns also are restricted from making traditional-to-Roth IRA conversions, except in certain circumstances.

So why should you convert? Because the pros may significantly outweigh the cons.

Triggering taxes

Let’s start with the cons. The conversion process causes the amount converted to be taxed. Essentially, you’re moving assets from an account funded with tax-deferred contributions (a traditional IRA) to one funded with after-tax dollars (a Roth IRA). If you converted a traditional IRA with $100,000 in assets to a Roth account and were otherwise in, for example, the 28% bracket, you’d likely be pushed into the higher 33% bracket for at least a portion of the amount. That extra 5% tax on, say, $50,000 would lead to an additional $2,500 in federal income tax.

To soften the blow, if you convert to a Roth IRA in 2010, you can report the income evenly over the following two years. Not only will you be able to defer recognition of the income, but you also may avoid being taxed at the higher rate. If you convert in later years, you’ll need to recognize income in the year of conversion. So, 2010 could be the best time to convert.

The case for converting

There are valid financial reasons for converting to a Roth IRA. First, required minimum distribution (RMD) rules don’t apply to Roth IRAs, making them a good option if you won’t need the retirement income and want to grow your retirement plan assets for your heirs.

Also, in contrast to traditional IRA contributions, Roth IRA contributions — and the amount converted from traditional IRAs — can be withdrawn at any time, free of penalties and taxes. However, early withdrawals of earnings on contributions are subject to taxes and early withdrawal penalties, though there are exceptions. Once you reach age 59½, you can take tax-free distributions so long as you’ve had the Roth IRA for at least five years. Roth IRAs are also more flexible than traditional IRAs with regard to contributions — there’s no age limit, for example.

When deciding if a Roth is right for you, bear in mind that traditional IRAs boast tax-deductible contributions and may be advantageous for people who anticipate paying taxes at a significantly lower rate at retirement age. That said, there’s still the RMD rule that comes with a traditional IRA.

Planning opportunities

Roth-related tax law changes present some interesting planning opportunities. For example, if you’re restricted from making Roth IRA contributions because your income is too high, you can contribute to a nondeductible traditional IRA in 2009 and later years, converting it to a Roth when ready.

But be careful: Although this works well when you have no other traditional IRAs, it can be problematic if others do exist. That’s because you can’t choose to convert just the nontaxable portion of the traditional IRA. Any conversion will be done on a pro rata basis. So, if you have $100,000 in a traditional IRA and only $5,000 is from nondeductible contributions, 95% of the conversion amount will be taxable. If, however, you don’t have any other traditional IRAs, making a nondeductible contribution will allow you to convert next year, and you’ll only have to pay tax on any earnings.

Generally, if you can convert traditional IRA assets into a Roth with little or no tax cost, you should seriously consider it.

One caveat: When converting to a Roth IRA, do so via a custodianto-custodian transfer, not by making a withdrawal from your traditional IRA and then opening a Roth account. You’ll need to complete the rollover within 60 days in order to avoid the negative tax consequences.

The final word

Now’s the time to consider whether converting your traditional IRA to a Roth version will benefit you, because 2010 isn’t that far away. And be sure to work with your tax advisor to determine which strategy is best for you before making any rollover moves.

Tax-free IRA-to-charity distributions extended

Looking for other possible uses of your traditional IRA? Are you (or will you be) over 70½ this year? Want to contribute to a favorite charity, but don’t know where to get the funds? Consider giving the charity money directly from your IRA. You can make a charitable distribution of up to $100,000 from an IRA to a qualified charity (or charities) by Dec. 31, 2009, and exclude the distribution amount from your income. Although you won’t get a charitable deduction for the amount distributed, the charity (or charities) will benefit and you’ll avoid any taxes you’d otherwise owe on the distribution.

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