Ready, Set, Go – for your 2010 Roth IRA Conversion
When the Roth IRA conversion law was enacted in 1997, taxpayers with adjusted gross incomes over $100,000 could not convert. No more. On January 1, 2010, every IRA owner will qualify for a Roth IRA conversion – there will be no income limitation.
When a traditional IRA is converted to a Roth, all before-tax contributions made to the IRA become taxable. But once the money is in the Roth IRA, it grows tax-free; and you can make tax-free withdrawals at any time provided that five years has passed. For a Roth IRA, there are no minimum required distributions after you attain age 70-1/2.
For Roth conversions in 2010, there is an additional benefit. The amount withdrawn does not have to be reported as part of your 2010 income. One-half can be added to income in 2011 and one-half in 2012. Conversions in 2011 and thereafter are included in income during the tax year in which the conversion is completed.
Since most IRAs took a beating in the market in 2007 and 2008 and still haven’t recovered, the taxes on a conversion will be less than they could have been. Even if the additional income due to the conversion pushes you into a higher tax bracket, it may be worth it if you would have to pay higher taxes on later minimum required distributions or if income tax rates go up. If income rates go up in the future, tax-free Roth IRA income will be more valuable.
Roth conversion is not all or nothing. You may choose to convert part of your traditional IRA to a Roth (although if you have multiple IRAs you must convert each of them proportionally).
If you convert and then decide you made a mistake, you have until October 15 of the year following the year of the conversion to recharacterize and go back to a traditional IRA.
Should you convert to a Roth? The short answer is that if you can afford to pay the tax out of non-IRA assets, you are unlikely to be hurt and may do very well. So go ahead and convert. If you need to make additional withdrawals from the IRA in order to pay the taxes on the conversion, don’t do it. The money you have to withdraw to pay the tax will be subject to income tax and penalties, and it will be gone – in the government’s coffers – not compounding tax-free in your Roth.
The question is more than can you “afford” to pay the tax out of non-IRA assets. It’s also, do you “want” to pay the taxes. Many people have a psychological aversion to paying any tax a minute before they absolutely have to. And in truth, many of these people have been proven correct. As we know, the tax law changes all the time. Wouldn’t it make you feel silly to have paid the tax on a Roth conversion and 15 years from now find that the law is changed in such a way that no tax on your IRA would ever be due?
The long answer is that you must consider a number of factors: the value of the IRA, the tax rate on conversion, when you think withdrawals will be needed, when you plan to retire, what your age and health is, what future income tax rates will be (that is a huge unknown) and other imponderables. Then do projections based on these variables and different assumed rates of return. Lots of planners will make money trying to crunch these numbers using software to generate and sell reports consisting of pages and pages of projections. My advice: skip all that and go back to the short answer.
If you want to convert to a Roth, do it as early as possible in 2010 on the theory that the assets may grow as the market recovers and the sooner you convert, the less the tax will be. It makes sense to start planning for the transaction now. Let the custodian of your IRA, the bank, mutual fund company, or other financial institution that holds your account know your intentions. Ask for the proper forms if they are already available, decide how you want your converted assets invested, determine whether you will pay the taxes in 2010 or take the 2-year deferment deal, decide whether you will pay the taxes yourself or whether you want the custodian to withhold taxes, and name a beneficiary for the Roth on your death.
The opportunity to have assets grow tax-free inside the Roth and be withdrawn with no tax is a valuable one. Albert Einstein said “The most powerful force in the universe is compound interest.” He was close, but not quite right. The most powerful force in the universe is the tax-free compounding of interest.