Beginning in 2010 anyone is eligible to convert a traditional IRA or 401(k) plan into a Roth IRA. Up to this point Roth’s were not for everyone, as there were two limitations on having a Roth IRA. The first limitation prohibited contributions to a Roth if your adjusted gross income was in excess of $110,000 (or $160,000 married filing jointly). The second limitation prohibited anyone with an adjusted gross income exceeding $100,000 from converting an existing traditional IRA or 401(k) to a Roth account. Starting next year, anyone can convert a traditional IRA or a 401(k) plan to a Roth IRA without regard to income level.
Roth IRA’s can be very attractive retirement vehicles, as all qualified withdrawals from the account are tax free. That’s right. Make a non-deductible contribution to a Roth IRA today and never pay tax on that money again –not on the amount deposited nor on the earnings in the account. In addition, there are no required distributions from a Roth IRA regardless of age. If you don’t need the funds that are in the Roth account leave them there and your heirs will not pay tax on it either. A Roth account must have been in place for five years prior to any withdrawals to receive the tax-free benefit.
Another advantage of a Roth account applies to working taxpayers over age 59 ½ who established their Roth more than five years ago. Since there are no taxes to be paid and no requirements about withdrawals, this group of taxpayers can use a Roth as a tax-free savings account.
If you have contributed to a deductible IRA, you must pay tax on the amount converted. So, if you have $50,000 in your IRA and wish to convert it to a Roth, you must include $50,000 in your taxable income. If you have contributed to a non-deductible IRA, you would only pay tax on the earnings on the withdrawal when converting to a Roth. If you made $30,000 in non-deductible contributions that have grown to $50,000, you would pay tax on $20,000 only. From the point of withdrawal, any additional earnings would not be subject to tax.
Although the $100,000 limit has been permanently removed, there is a unique opportunity in 2010. For any conversion that is completed in 2010, the taxes on the conversion can be deferred and spread over two years, 2011 and 2012.
So, should you convert your existing traditional IRA to a Roth? Unfortunately, there is no one correct answer to that question other than “It depends.” Without doubt, anyone with more than ten years until retirement should consider such a move. There should be a significant amount of growth in the account prior to retirement and tax rates are likely to increase over time. Paying taxes now at a lower rate and on fewer dollars makes sense. The remaining issue is your ability to pay the extra tax at this time.
For taxpayers closer to retirement, the choice is not as clear-cut. There is likely be an advantage to anyone converting regardless of the time span – assuming the market increases. Probably the worst scenario is to convert to a Roth account, only to see the value of your account decline.
Assuming the market does not go into a decline you must weigh several factors in the decision to convert.
- How soon do you anticipate retirement and use of the funds? In other words, how much opportunity is there for the money in your account to grow? The longer the time frame, the greater the benefit to be obtained by converting.
- How does your tax situation compare now to when you are retired? Will your marginal tax rate decline upon retirement? If so, it might be more advantageous to keep the traditional IRA and pay tax on your marginal rate in retirement. Keep in mind that converting to a Roth could place you in a higher tax bracket for the year of conversion, resulting in more tax being paid.
- Without regard to your current marginal rate, what do you anticipate for the future? The current individual tax rate structure is historically low. Remember that in the early 1960’s the top marginal rate was 91 percent, a far cry from today’s 35 percent. Considering that the federal government is currently running historic deficits, it is not wild speculation to think that rates may increase in the future.
- A final issue is your ability to pay the additional tax in the year of conversion. If you do not have the cash available or must borrow the money to pay the extra tax, converting is probably not a wise move.
As stated earlier, the answer is not a “one size fits all.” You will need to take a hard look at your financial situation and expectations about the future to make an intelligent choice. Your financial professional can assist you in modeling various scenarios and help you make the right choice.
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2 users responded in this post
next year my wife and i are expecting our first child, so we’ll be getting that deduction that we won’t get in 2009. my traditional IRA (funds from 2 converted 401k plans) has less than what you used in the example above. is there any way i can figure out if the child credit would balance out additional taxes i would have to pay due to the conversion?
Of course, the tax would not be due in 2010, it can be deferred to 2011 and 2012. It gets a little complicated to equate the two. Suppose you are in the 25% bracket, then the child credit of $1,000 would offset $4,000 in income. If you’re not in that bracket divide your marginal rate by $1,000 to get that effect. Then add $3,650 for the dependency exemption. The two amounts combined represent how much IRA you could rollover with no net tax effect.
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