Last Updated: November 24, 2010
While individuals with adjusted gross income of more than $100,000 have been eligible to convert their traditional Individual Retirement Accounts (IRAs) to Roth IRAs since the beginning of the year, there’s a tax consideration that may make it a good idea for some who haven’t made the move to do so by the end of the year.
Anyone who makes a Roth conversion by Dec. 31 will have a three-year window to pay those taxes, a potentially substantial issue for those converting sizable amounts of assets to a Roth.
Keep in mind that a conversion might be a good idea for people in lower income tax brackets. A tax expert or a qualified financial planner can help you decide.
Traditional IRAs allow investors to save money tax-deferred with deductible contributions (within certain income limits if either spouse is eligible for a qualified plan at work) until they’re ready to begin withdrawals anytime between age 59 ½ and 70 ½. Roth IRAs don’t allow tax-deductible contributions, but they allow tax-free withdrawal of funds with no mandatory distribution age and allow these assets to be passed to heirs tax-free as well. If you leave your savings in the Roth for at least five years and wait until you're 59 1/2 to take withdrawals, you'll never pay taxes on the gains. You can convert a traditional IRA to a Roth, but you must pay taxes on any pre-tax contributions, plus any gains.
Remember that when you do a conversion, you must pay income tax on the amount you are converting. Since you received a tax deduction on your initial contributions to most traditional IRAs, you must pay the taxes due on those initial contributions and any growth in your IRA. But, subject to certain restrictions, you won’t pay tax when you finally need to withdraw your money. That’s where the silver lining comes in for you, or for your heirs if you pass that money on to them.
The conversion issue is a potentially attractive retirement and estate-planning idea for all Americans who want to make sure they maximize the assets they have for themselves and for their heirs on a tax-free basis. And the conversion option isn’t available just for traditional IRAs — it can be used for retirement assets held at other employers and 401(k) holdings. But anyone considering such a move – regardless of his or her income status – should first review their current retirement asset strategy with a professional.
Things to consider:
How close is retirement? If you have more than five years until you plan to withdraw your retirement funds, conversion of traditional IRA assets to a Roth IRA might make sense. The longer the time span where earnings can grow tax deferred, the greater the benefit of being able to withdraw those earnings without paying tax on them.
What will your tax rate at retirement be? Many people, such as business owners, may be paying taxes now at a fairly low rate. So they might pay higher taxes at retirement. If that’s the case, converting to a Roth might make a lot of sense. Additionally, with Social Security benefits being taxable at certain income levels, Roth IRAs can allow you to limit or eliminate such taxes.
Will you absolutely need to use all the money? Converting to a Roth is a good idea for those who won’t need to tap the account every year (Roth’s don’t require minimum distributions as do traditional IRAs). Heirs will inherit the money tax-free.
A Roth conversion can be expensive – can you afford it? You’ll have to pay taxes on contributions that you previously deducted, as well as taxes on the accumulated earnings. Also, you need to be aware that a conversion could push you into a higher tax bracket, especially if you've accumulated sizeable earnings over the years. This is why a conversion needs to be planned with a tax expert. Why? It may trigger the Alternative Minimum Tax (AMT) due to those high earnings.
Know how the conversion window will work: Keep in mind that 2010 is the year you will be able to convert the income to be claimed that can be deferred until 2011 and 2012. The Internal Revenue Service has granted taxpayers the option to claim 50 percent of conversion amount as income in 2011 and the remaining 50 percent in 2012. Also, you have to understand that if you choose the conversion period, your tax will be based on the bracket you fit that year. That means swings in income will affect what you pay.
Be careful about your child’s college financial aid: Converting to a Roth will increase your taxable income for the year of the conversion — or for 2011 and 2012 if you make a 2010 conversion and choose to spread the tax bill over those years. Check with your tax adviser and your child’s financial aid office — it could affect your child’s ability to qualify.