By FPA member Eric Toya, CFP®
Last Updated: March 1, 2010
Prior to 2010, anyone with an income of more than $100,000 was prevented from converting a traditional Individual Retirement Account (IRA) to a Roth IRA. As of January 1, the income limit was removed. If you have previously been unable to contribute to a Roth IRA, this may present an opportunity for you.
How does all this work?
Traditional IRAs allow you to make tax deductible contributions. All growth is tax deferred, however withdrawals are taxed as income. Contributions to Roth IRAs are not deductible, but your qualified withdrawals are tax free.
By converting a traditional IRA, you pay taxes today on the amount of the conversion in exchange for tax free growth going forward. One exception: income resulting from conversions completed in 2010 may be split in half and reported in 2011 and 2012.
Should you convert your IRA to a Roth IRA?
Unfortunately, there is no simple answer. All calculations are subject to assumptions or predictions about future income tax rates, projected growth rates, the amount and timing of future distributions and even your life expectancy.
You should consider a Roth IRA conversion if:
- You expect that your marginal income tax rate will be higher in the future than it is now. This is not necessarily an expectation that your income will be higher, as tax laws may change.
- You have funds available in non-retirement accounts or through current income to pay the taxes that will be due. The benefit of conversion is generally lost if you pay the taxes out of your IRA.
- You expect to live a long life. Traditional IRAs have mandatory distributions beginning at age 70 ½, which can be a drag on your ability to maintain wealth and manage your taxes.
- You are young or have a long time before you expect to use the converted money.
- You anticipate a large taxable estate or expect that monies converted will not be spent in your lifetime.
Strategies for Roth IRA conversion
If you complete a Roth IRA conversion, you have until your taxes are filed to undo part or all of the conversion. This is known as recharacterization. The ability to recharacterize part of a Roth IRA conversion presents some unique planning opportunities. Consider splitting up your conversion into multiple Roth IRAs, each holding a different type of investment. This will give you the ability to be selective in the event you decide to recharacterize the conversion. For example, you may decide that it makes sense to recharacterize only the accounts holding the worst performing investments.
If you make more than $120,000 as a single person or $176,000 as a joint tax filer, you are not allowed to make a Roth IRA contribution. You may be eligible to make a traditional IRA contribution, but that contribution is likely not tax deductible if you or your spouse are covered by an employer sponsored plan, such as a 401(k) plan. Under current tax law, one option for high income households is to make a non-deductible traditional IRA contribution, then immediately convert that account to a Roth IRA. The end result is effectively the same as making a current year Roth IRA contribution. Some in the financial planning community believe that the Internal Revenue Service (IRS) will disallow this option, so be sure to consult your tax adviser before proceeding.
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Eric S. Toya, CFP®, Vice President of Wealth Management for Trovena, LLC. graduated from the University of Southern California with a BS in Finance and Accounting. Eric has been quoted in national publications, including the Wall Street Journal, Money Magazine and the Los Angeles Times.