Is Now The Time to Convert Your Traditional IRA to a Roth IRA?

 

With great adversity comes great opportunity. While nobody likes to see the account balances in their IRA drop 40% or more, the reduced value in your IRA may make it an opportune time to convert your Traditional IRA to a Roth IRA since it will cost you much less in taxes than it would have in any of the past 4 years.

Traditional IRA vs. Roth IRA Basics

A Traditional IRA allows you, with some limitations, to deduct your IRA contribution when you make it. Over time, your account grows tax-free until you start taking distributions. Once you begin to take distributions, the amount you take each year after age 59 ½ is taxed at your rate at your current income tax rate.

A Roth IRA on the other hand, does not provide you with an up-front tax deduction. Like the Traditional IRA, your account grows tax-free but, unlike a Traditional IRA, when you take distributions there is NO tax liability.

Why Convert?

Roth IRA’s have four big advantages:

1. Tax-free growth. Like a Traditional IRA, the growth in your account is not taxes.
2. Tax-free withdrawals. As long as you’ve owned your Roth IRA for five years or have reached age 59 ½, the amount you take out of the account is not taxed.
3. Contributions can be made after age 70 ½. While you can longer make contributions after age 70 ½ in your Traditional IRA, there is no such restriction for the Roth IRA.
4. No mandatory distributions. In a Traditional IRA, one you reach age 70 ½, you must start taking Required Minimum Distributions (RMD’s) each year from the account. Because you didn’t get an up-front tax deduction for your Roth IRA, you’re not required to take RMD’s.

Reasons Not To Convert

1. Taxes. When you convert from a Traditional to a Roth IRA, you’ll need cash to pay taxes on the earnings and pre-tax contributions you made. Warning: you can’t use your IRA to pay the taxes since the amount you use for taxes would be considered an early withdrawal, subject to income tax and a penalty.
2. You anticipate being in a lower tax bracket in the future. If you’re currently in the 35% tax bracket and you think you’ll be in the 25% bracket in retirement, you’ll be paying taxes at your higher current rate.

Who Is Eligible to Convert?

In 2009, in order to be eligible to convert your IRA, you must have an Adjusted Gross Income (AGI) of less than $100,000. In 2010, there will be no income limitation on a Roth conversion.

Do-Over

If the market continues to tank through 2010, the government has provided you with the ability to take a mulligan. Otherwise known as a ‘re-characterization’, this give you until October 15, 2010 to reverse your decision to do the conversion in 2009 and re-do it on the new lower amount in your IRA.

Consult a Professional

The tax code is a fluid, complex animal. Before undertaking this type of conversion, be sure to consult your CPA or tax professional to ensure that you do everything right to avoid an unnecessary complications.

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