If you are investing in an Individual Retirement Account, financial advisors say it may be time to convert your traditional IRA to a Roth IRA. The key difference between the two is that income you contribute to a Roth IRA is not tax-deferrable. Withdrawals from a Roth IRA are tax-free if the account has been open five years, so Roth accounts must be better, right? Not necessarily.
Roth IRA conversions are attractive this year because, for the first time, the income limits have been removed. That means you make as much as you want, put it into your traditional IRA retirement account and still have the option to convert it to a Roth.
“There is no income limitation imposed on conversions in 2010, and this is huge not only for high-wealth clients but also for anyone who had AGI over $100,000,” says Scott Loden, CPA and president of Loden, Fraze and Associates. “Before, people who earned above the income limitations could not convert to a Roth. This year they can. You can make a million dollars and still convert traditional IRA funds into a Roth.”
The Benefits of a Roth Right Now
The downside of a Roth IRA is that you pay taxes immediately on the amount you convert, at your current tax rate (the amount you convert is considered ordinary earnings). You change to a Roth; you owe the IRS. However, that’s good news for many right now, because accounts may still be somewhat deflated, and their businesses may have taken a loss, putting them in a lower tax bracket. Also, in a typical year, IRAs with stock holdings are worth more at the end of a calendar year than at the beginning. So the sooner you convert, the better it may be in terms of taxes you will pay.
Why should you consider paying taxes now, when you can just let the money sit and deal with the tax bill when you retire? After all, if you are no longer earning money, your income tax bracket should be lower, right? Maybe, but who can predict what tax rates and inflation will look like in the far-distant future? With a Roth, once you pay the initial taxes, anything that investment earns grows tax-free. Permanently. (Well, as permanent as anything can be in federal tax regulations.)
“If you convert $500,000 and pay Uncle Sam his piece up front, it grows tax-free from there on out,” Loden says. “Whether you end up with a million or two million, there are no more taxes owed on those dollars.”
An added federal incentive for converting this year? You can take two years to pay the taxes you owe, with the final bill coming due in 2012. And you are paying at your 2010 tax rate. If you earn more as your career grows and if tax rates increase, with a traditional IRA you will pay taxes when you begin withdrawals at whatever the tax rate is at that time. You’ll also pay at your current tax bracket, on the amount you invested plus all the interest you have earned.
“With the current governmental spending and state of the economy, if you are a middle- to high-wage earner your taxes are very likely to go up,” Loden says. “With the new programs planned and impending healthcare reform, somebody has to pay for it. And the current thinking is that those with a higher income can afford to pay more taxes.”
Finally, if you try converting to a Roth in the first nine months of this year (or any year) and decide you are not better off, the government gives you a “do-over” card called “recharacterization.” Basically, that means that if you don’t like what you did, you can calculate what you converted, plus any earnings, and return it to a traditional IRA. Just let the IRS know by October 15.
The Downside of a Roth Conversion
There are some cautions to converting: Contributions to a Roth IRA are never tax-deductible, while contributions to a traditional IRA may be, depending on your income level. Also, if you are retiring soon and your taxable income will drop considerably, your taxes when you begin withdrawals from your traditional IRA may be less than if you converted now, because you would land in a much lower tax bracket. Another thing to consider is that in retirement, your major expenses may be property taxes and medical expenses, much of which are tax-deductible and somewhat “sheltered” from a lot of taxation.
There’s also a risk with a Roth that converting could put you into a higher tax bracket, because the conversion is deemed income. You can avoid this by converting only a portion of your traditional IRA now and converting more in future years.
But if your IRA is a place where you want to accumulate funds to pass on to your heirs, and you never want to spend it, converting to a Roth helps in estate planning because it gets rid of the rules that force you to withdraw from a traditional IRA at the age of 70-1/2. This allows the account to keep earning and gets the estate tax out of the estate.
“We are going to our clients and discussing the options and doing the calculations for them to see if it is beneficial to convert to a Roth,” Loden says. “For some of our clients, this is a move that could set them up for life. For others, it positions assets where they need to be for generations to come.”
Loden says while there hasn’t been a rush of clients looking to convert, more are asking questions and getting educated on the new rules.
“It’s going to be a factor that plays beyond tax season,” Loden says. “Toward the end of the year, that’s when we will see a lot of people.”
Natalie Nichols Gillespie is the former Editorial Director of WEALTH magazine and now a freelance contributing writer.
