The 2010 Opportunity for Special Roth IRA Conversion
Significant Differences between a traditional IRA and Roth IRA
1. In traditional IRA, assets grow on a tax-deferred basis; thus, you get tax deduction now for contributions made. However, you have to pay taxes on distributions from the IRA in retirement. Whereas with Roth IRA, contributions are determined after tax, which means you do not get any tax deduction for contributed dollars. Assets frown on a tax-free basis and distributions upon retirement (or after age 59 1/2) are also income tax-free.
2. Roth IRA allows you to make contributions even after age 70 as long as you (or your spouse) have earned income. You are not allowed to do this in traditional IRA.
3. Traditional IRA owners are required to take minimum taxable distributions upon reaching the age of 70 1/2. Roth IRA has no such requirement and you are not obliged to take distributions.
The Special Roth Conversion Rules for 2010
In the past, conversions were only allowed for people with Modified Adjusted Gross Income (MAGI) of $100,000 or less. Starting January 1, 2010, however, this income cap is eliminated and the option becomes open to everyone.
On other positive modification is the option to defer the recognition (and subsequent tax payment) of income on conversion, spread equally to 2011 and 2012. For instance, if you converted $200,000 of your traditional IRA assets to Roth in 2010, you have the alternative of recognizing $100,000 of that income in 2011 and the other $100,000 in 2012. You have to wait for five years after conversion before you can withdraw any money from Roth that is tax-free.
What is the Catch?
You have to be willing to write a huge check to convert to Roth IRA. You have to recognize the converted amount as income; therefore you must pay the corresponding tax for that amount. To illustrate, if you want to convert $200,000 in IRA assets to Roth, you may have to write a check for $80,000 (based on assumption of 4% marginal tax rate) to pay the taxes on the conversion - either now or spread over 2011 and 2012 (as previously discussed).
Moreover, you have to pay those income taxes from a taxable account and not from your IRA or 401K. So, to convert, you must have enough money in a separate taxable investment account and should be willing to write a huge check to pay those taxes.
This in effect, defeats the purpose of the conversion, especially if you are below the age 59 1/2, which will subject you to another 10% penalty as well. For most people it is tough enough to voluntarily pay more taxes now, but even more so, when you consider the many years in between before you can avail of the benefits. This also goes counter to conventional tax planning, which practically intends to defer tax payment as long as possible.
Who Should (and Should not) Consider Converting to Roth?
The way things are, Roth conversion seems to be more favorable to the wealthy persons who expect higher tax rate in retirement that what they are paying now; and who will not be spending any of their IRA assets in retirement, anyway. Those who expect to live a longer time and plan to leave their Roth IRA assets to the next generation may also find the conversion a smart move.
Because Roth does not have mandatory distribution beginning age 70 1/2, the extension of tax-free life of your retirement assets can result in potentially larger legacy for your heirs. Some people may take advantage of their lower than usual tax rate and consequently benefit from a partial Roth conversion, during a time when their income and tax rate are down for any reason, like maybe during recession or tax losses.
People who cannot afford to pay the tax on conversion now will not want to convert to Roth. Also those who do not have substantial assets in a separate account outside of their IRA or 401K to cover tax payments and those who anticipate a lower tax rate than what they have now are better off not doing any conversion. If you are nearing retirement and have not saved enough, it is a smarter choice to stay put and not do any conversion. It will also be a lot convenient for older people who plan to leave their IRA assets to charity to stick with their present IRA.
Partial Roth IRA Conversion and Tax Rate Diversification
A lot of investors opt for partial rather than a 100% Roth IRA conversion, which may actually be a smarter move. Another option is to spread your Roth conversions over several years to stretch out the income and corresponding tax hits. Having a combination of some Roth IRA assets, which has tax-free distributions and some traditional IRA assets with taxable distributions may be a good opportunity to diversify your future tax rate bet. This will give you a lot of leeway for more creative tax planning in retirement by timing your withdrawals from different pools of assets with different tax implications. Partial conversion from traditional IRA to Roth is a good dodge to future tax rate increases.
Risks of Converting to Roth Now
There is always the risk that the US government will drastically alter the Roth rules and somehow limit the tax-free status of your Roth IRA status; or worse, it may someday make Roth withdrawals taxable and impose taxes as a way of offsetting some government deficits. On the other hand, you may still be able to withdraw the Roth assets you had at the time of the conversion tax-free, since you have already paid the conversion tax; but taxes on investment gains earned after conversion may not be tax-free. The effects of these scenarios would depend on a lot of factors, such as your tax bracket and investment return.
A word of advice: Get professional help. This may get complicated as there are many significant factors to consider with a Roth conversion; some of which are not mentioned here (like the alternative minimum tax, for example) due to the need for a more in-depth and lengthy discussion. Each persons situation is unique; consult your CPA and investment advisor to see if a Roth conversion is an option that will work for you.
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No. of Times this article has been viewed : 327
Date Published : Dec 26 2009
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