If you want to get the most bang for your retirement-buck, it’s time to read up on an popular but confusing tax-saving tactic, the Roth IRA conversion.
A Roth IRA conversion allows you to pay income taxes on money you have invested tax-free in a traditional IRA this year instead of when you withdraw the money at retirement. (Because once you convert to a Roth IRA, distributions at retirement are tax-free).
Roth conversions are hot because as of Jan. 1, 2010, the IRS lifted income limitations on converting a traditional IRA to a Roth IRA. Formerly, conversions were only available to investors with a modified adjusted gross income (MAGI) of less than $100,000. Because investors who earn more than a certain amount also cannot contribute to Roth IRAs, a Roth IRA conversion presents a new opportunity to many investors to take advantage of the Roth IRA’s benefits. Additionally, there’s a special rule this year only that allows investors to recognize all of the conversion income in the 2010 tax year or split it equally between the next two tax years (2011 and 2012).
Read This First! Despite all the buzz about Roth conversions, only a relative few investors should use them. If you’re currently eligible to contribute to a Roth IRA or have a Roth 401(k) at work or you can’t contribute to a Roth but are planning on converting and using assets in your traditional IRA to pay income taxes for the conversion, stop. You probably shouldn’t convert and probably don’t need to read this.
Still curious? Okay. Before we examine exactly who should consider an IRA conversion, here’s a quick refresher of IRA basics.
Roth IRA vs. Traditional IRA
Traditional IRA: Contributions to a traditional IRA are tax-deductible the year you make them but come retirement, withdrawals are taxed as income. If you’re not covered by an employer-sponsored retirement plan like a 401(k), there’s no income limit for deducting traditional IRA contributions.
If you do have a 401(k) or other employer-sponsored plan a traditional IRA contribution is fully deductible for 2009 up to IRA contribution limits. That’s $55,000 for single filers; phase-outs begin between $55,000 and $65,000. For married couples filing jointly, “deductibility” phases out between $89,000 and $109,000 (or between $166,000 and $176,000 if one spouse doesn’t have an employer-sponsored plan).
Traditional IRAs make sense if you can deduct all of your contributions, but since long-term capital gains are taxed at a lower rate than ordinary income, if you cannot deduct contributions, you’re better off investing in a regular brokerage account.
Roth IRA: Contributions to a Roth IRA are not tax-deductible, but your earnings can be withdrawn tax-free after age 59-and-a-half.
In 2009, single filers’ ability to contribute to a Roth IRA phases out if MAGI is between $105,000 and $120,000. For married couples filing jointly, eligibility phases out between $166,000 and $176,000. Whether single or married filing jointly, filers may only contribute up to $5,000 total to all IRAs.
If you qualify for either a Roth IRA or a fully-deductible traditional IRA, most experts advise contributing to a Roth IRA if you have many years to go before you retire and you expect to be in a higher tax bracket at retirement.
Indeed, many financial writers herald the Roth IRA as the greatest financial product around. If you’re eligible, you should certainly contribute to a Roth IRA. But why wouldn’t you want to convert a traditional IRA to a Roth IRA?
Who Should Convert
You should consider a Roth IRA conversion if:
- You earn too much to contribute to a Roth IRA.
- Your employer does not offer a Roth 401(k) option.
- You have a sizable balance invested in a traditional IRA.
Does this sound like you? Then it is still possible to tap a Roth IRA’s potential benefits by converting some or all or your traditional IRA money to a Roth IRA. You should consider converting if:
- You expect to be in a higher tax bracket at retirement.
- You have a long time to go before retiring or
- you don’t plan to use the money and want to leave it to heirs. And:
- You’re not going to use IRA assets to pay income taxes on the Roth conversion.
Although I run the risk of oversimplifying a rather complex financial planning decision, if most of the above situations don’t apply to you, I would not consider a Roth IRA conversion. Even if you have a big traditional IRA balance, I would simply focus on making Roth contributions going forward. Come retirement, you’ll have to pay taxes on some income, but not all.
So You Want to Convert
If you convert a traditional IRA to a Roth IRA, you will pay income taxes on the amount in your account (but avoid the 10 percent early withdrawal penalty that you would pay for a cash distribution before retirement, as long as you reinvest in a Roth appropriately). In 2010 only, you can pay the taxes on that “income” this year or over the next two years (2011 and 2012).
It’s important to consider that depending on your traditional IRA balance, converting could put you into a higher tax bracket this year and, of course, you’ll need to come up with the cash to pay that tax bill.
As I mentioned earlier, if you pay the taxes from your IRA, you would lose the potential benefit of tax-free growth on that amount which significantly deflates the value of the conversion in the first place.
If you’ve gotten this far and still think a Roth conversion is right for you, contact an investment professional. (If you don’t have one, at least call the 800 number of the brokerage that holds your IRA). And after you convert, you’ll probably want a tax professional on your side as well. A Roth Conversion is big opportunity for some investors, but not all. Good luck!