Finance & Enjoyment Blog

Roth IRA’s (named after Representative Roth who was chairman of the House Ways and Means committee at the time) have been in existence since 1998.  They are only available to individuals with earned income and adjusted gross incomes below established levels.  Roth IRA’s are advantageous because:

  1. Virtually all future income, growth and withdrawals are tax-free
  2. You are not required to take distributions after age 70 1/2, as you are with traditional IRA’s

Taxpayers with adjusted gross incomes below $100,000 have been permitted to convert traditional IRA’s to Roth IRA’s, but the conversion is subject to current income tax on the deductible contribution and investment earnings (non-deductible contributions can be converted free of tax).

Beginning January 1, 2010, the $100,000 AGI limitation has been removed allowing anyone, regardless of income level, to convert a traditional IRA to a Roth IRA.  Of course, the previously deducted contributions and all investment earnings will be taxable.  Another special rule for conversions in 2010 is that none of the income tax is due with the taxpayer’s 2010 tax return.  Instead, one-half of the tax on conversion is included in the taxpayer’s 2011 income return and the other one-half in the 2012 income return.  Since many of us believe that tax rates will be higher in 2011 due to the provisions which will sunset December 31, 2010 and the Treasury Department’s “green book” released in May 2009 calling for replacing the existing top bracket of 35% with a 36% bracket and a new 39.6% bracket, taxpayers who convert in 2010 may want to elect to pay the tax on the conversion with their 2010 tax return.

Converting a traditional IRA to a Roth makes more sense for a younger individual than an older person because the younger person has more time for the IRA to grow tax free.  Also, if an individual expects to be in a higher tax bracket in retirement, conversion now would save tax.  Alternatively, if an individual expects to be in a lower tax bracket in retirement, then a conversion now probably would not make sense.

Coming up with the cash to pay the tax on the conversion will probably be the biggest hurdle to overcome.  While an individual can pay the tax out of funds being converted, doing so reduces the amount eligible for tax free growth in the Roth.  In addition, the amount withheld will be a taxable distribution and if the individual is under 59 ½, a 10% penalty may apply.

Maybe the best part of a Roth conversion is that a taxpayer can change his mind later.  This would be desirable if the IRA declines in value.  The taxpayer has until the due date of his 2010 tax return (October 15, 2011, if an extension is filed) to recharacterize (“undo”) the converted amount back into a traditional IRA.  For example, in January 2010, a taxpayer converts a $200,000 traditional IRA into a Roth.  In June, 2011 the IRA declines in value to $150,000.  The individual could recharacterize the conversion back into a traditional IRA (assuming his 2010 tax return has been extended.)  If he waits at least 30 days, he could make a conversion back to a Roth in 2011. 

Keep in mind you may convert any amount you choose.  You are not required to convert the entire amount of your IRA, and can choose to make piecemeal conversions over time.

In our opinion, we recommend converting to a Roth only in the following situations:

  • If you believe you will be in a higher tax bracket in the future than you are now
  • You have the cash from other sources to pay the tax.
  • If you won’t need your required minimum distributions and wish to provide a  source of tax free income to children or grandchildren

Remember, we are opining based on tax laws as they exist today.  Given the enormous budget deficit which exists (and is only expected to increase in the future), Congress can always change the taxation of Roth IRA’s in the future.  For example, in the future Congress could say all of the growth in a Roth IRA after the conversion is taxable, or, more likely, all growth after the date of a tax law change will be taxed.

We can help you to know if a Roth conversion makes sense for your financial picture.  Call us at 303-815-1100 if you would like to discuss this strategy.

Posted in Your Financial House » Retirement and Exit Strategies »

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