Roth IRA ConversionsSubmitted by Grunden Financial Advisory, Inc on December 1st, 2009
There is a window of opportunity approaching next year that may offer you the chance to fund a Roth IRA that has been previously out of reach. This could be the only chance for many investors to make substantial changes to the tax status of their investments.
Investors who convert a Traditional IRA to a ROTH IRA will pay tax on the entire amount converted today for the benefit of allowing the assets to grow tax free into the future. This means that the tax bill could be substantial. However, investors do not need to convert an entire traditional IRA balance all at once. They can simply transition a portion of it in order to eliminate creeping into a higher tax bracket. To help alleviate the tax burden, Uncle Sam is allowing those participating individuals a one-time opportunity to spread the tax income from the conversion over the 2011 and 2012 tax years.
Starting next year, 2010, investors at any income level can convert traditional IRAs to ROTH IRAs. Previously, a modified adjusted gross income (MAGI) limit of $100,000 prevented many from taking advantage of a conversion.
Contributions to a ROTH IRA can be withdrawn tax free and penalty free at any time. Any growth component within the Roth may be withdrawn tax free on the 1st of January of the fifth year after the Roth was established if the investor is at least 59 ½. If not, the growth component withdrawal is taxed as ordinary income and may also be subject to a 10% penalty.
The benefits of a ROTH IRA can often outweigh those for a traditional IRA and include:
- Normal distributions are completely tax free whereas distributions from a traditional IRA are subject to ordinary income taxes. This should make a conversion advantageous for someone whose tax rates are lower now and expected to be higher in the future. Also, this tax diversification allows for greater flexibility to adjust income streams in retirement and minimize taxes.
- The IRS doesn't require ROTH IRA holders to make Required Minimum Distributions (RMD). This makes the ROTH attractive even if an individual is in the same tax bracket at retirement. Also, it is a great tax-free way to build wealth for heirs.
- The traditional IRA money converted to a ROTH IRA may be withdrawn without penalty or taxes after the five-year period. For example, a 40 year old converts a $50,000 traditional IRA to a ROTH in 2010. Five years later, at only age 45 and 15 years before the age for a normal distribution (59 ½), this investor can withdraw his original conversion amount ($50,000) tax and penalty free.
The downsides to converting to a ROTH IRA are:
- The money converted from a traditional IRA to a ROTH is fully taxable as ordinary income. Taxes may be paid at a higher rate if predictions about future tax rates and an individual's brackets are incorrect.
- The converted money must remain in the ROTH for a minimum of 5 years, even if the investor has attained age 59 ½, the point in time when distributions are typically penalty-free.
- The perceived tax benefit may never be realized if the account holder dies prematurely or if an individual's tax rates or brackets are lower in retirement.
- The possibility exists that Congress may change the laws that allow for tax-free distributions from ROTH IRAs.
A conversion may be appropriate for some investors and not others. The goal is to pay any tax liability when taxes are their lowest. This requires forecasting future tax rates. Additionally, the future wealth and income of an individual must be estimated. Given that uncertainty, it may be more appropriate to convert portions of a traditional IRA to take advantage of current tax rates without moving the investor into the next higher rate. For some people, converting a traditional IRA to a ROTH may actually cost them additional money over time so it is important to review this strategy in detail before implementing.