|
Roth IRA Conversion - What does it all Mean?
Up until now, those earning more than $100,000 in Modified Adjusted Gross Income (MAGI) were ineligible to convert a Traditional IRA to a Roth IRA. The Tax Increase Prevention and Reconciliation Act of 2005 eliminated this $100,000 ceiling for years after 2009. What’s more, for 2010 (and 2010 only) the tax burden can be split 50/50 over 2011 and 2012 with half of the IRA value added as 2011 income and half to 2012 as income. The elimination of the $100,000 ceiling is still in effect after 2010 (barring future legislation), but the value of the IRA will be treated as income in the year of the conversion.
What makes a Roth IRA different
Roth IRAs are funded with after-tax dollars, and the earnings come out tax-free. The government is going to get its money, so when you convert a Traditional IRA to a Roth IRA, you have to pay tax on the value of the IRA. If you have made non-deductible contributions, the process is a bit different.
Strengths of a Roth IRA
- Withdrawals are completely tax-free if made at least 5 years after you first establish any Roth IRA or 5 years after you convert (so long as you are over 59 ½).
- Roth IRAs are NOT subject to Required Minimum Distributions (RMDs).
- The funds used to pay the conversion tax are removed from your taxable estate.
- The funds used to pay the conversion tax are no longer part of your countable assets for purposes of determining financial aid.
- Qualified distributions from Roth IRAs are not included when determining the taxable portion of Social Security benefits.
- You can leave your heirs tax-free income.
Trade-offs with Roth IRAs
- You have to pay tax now (or for 2010, in 2011 and 2012).
- Using IRA funds to pay the conversion tax greatly reduces/eliminates the intended benefit.
- Taxable income resulting from the conversion can increase the taxable portion of your current Social Security benefits.
- Each conversion starts the 5 year holding period all over again (for that particular conversion amount)
- The laws could change.
- If you need to take a premature distribution on a converted Roth IRA within the 5 year holding period, the penalty can be more severe.
You can “recharacterize” (i.e. undo) the conversion within a certain period of time. You may want to think about establishing several Roth IRAs with different assets and investment goals. If the asset goes down in value, recharacterize back to a traditional IRA and not pay the tax.
If you think you will be in a lower tax bracket when you take distributions from your IRA, converting to a Roth IRA probably is the wrong option for you. If you think that you will be in a similar or higher tax bracket (either because of increased income or a change in legislation), converting to a Roth may be worth discussing, especially if the value of your IRA is down a bit.
| 
