Evaluating the Roth IRA Conversion Opportunity

Since the creation of the Roth IRA, there have been income limits that have prevented higher earning households from opening Roth IRAs or converting traditional IRAs to Roth IRAs. On January 1, 2010, income limits will be eliminated. This will allow any interested investor to convert traditional IRAs to Roth IRAs.

Complacency with monitoring our accounts’ diversification can lead to unnecessary risk. It is best not to be complacent when considering the current IRA conversion opportunity. It can be beneficial for many investors, and now may be a great time to consider whether it is right for you.

What is a Roth IRA?

Roth IRAs allow investors to put money aside for retirement. Money added to a Roth IRA does not get an immediate income tax deduction. There is no benefit upfront. The benefit comes later.

Investors will not pay income taxes on all gains earned on that money. Any cash flow from these accounts in retirement is completely free of state and federal income taxes.

Converting traditional IRAs to Roth IRAs

Investors can convert some or all of the funds in their traditional IRAs to Roth IRAs. In the year of conversion, the investor will be required to pay income taxes on the amount converted. However, the benefit is that the funds will never be taxed again, regardless of the gain earned.

Benefits of converting

With our retirement account values down after the market fall of the last two years, now may be a good time to convert a traditional IRA to a Roth IRA. Not only will the income tax liability be lower, but we can also take advantage of tax free gains as the market recovers.

Conversion may be good if we anticipate that our tax rates will be higher in retirement. While our highest marginal tax rate is 35% now, it has been higher in the past. Converting now enables us to pay at lower marginal tax rates than what may be in place when we choose to retire and start taking distributions.

We will also have the benefit of being in a lower tax bracket in retirement since the income we receive from the Roth IRA will be tax-free.

Another benefit of conversion is the ability to provide a lifetime of tax-free income to our beneficiaries. A stretch Roth IRA is similar to a stretch traditional IRA in that beneficiaries can take the required minimum distribution each year over their life expectancies. However, the Roth IRA option allows for both tax free growth and tax free distributions.

Before you convert, consider these issues

We should, however, make sure that we have sufficient funds available outside of our retirement accounts to pay the taxes required in the conversion. Funds cannot be taken out of a retirement account without penalty, so it is important to plan ahead to make sure funds are available before deciding to convert.

There will be an opportunity to spread the taxable income converted in 2010 over two tax years – half in 2011 and half in 2012.

We can also spread the conversion out over several years to spread out the tax payment. This may be important to keep from pushing ourselves into a higher marginal tax bracket.

This conversion opportunity can be of great benefit, especially in these current economic times. If your modified adjusted gross income (MAGI) is below the current threshold, the best window for the conversion is now. If your MAGI is too high, the conversion date is fast approaching. In either case, it is important to talk to your financial professionals now to determine if this is right for you.