Roth IRA Conversions Yield Potential Tax Benefits

8/5/2010

By Mark Corey, CPA

Beginning in 2010 there is an opportunity for traditional IRA owners to convert to a Roth IRA with some potential tax advantages.

Roth IRA Conversion Basics

In prior years there have been serious limitations to converting a traditional IRA to a Roth IRA including income limitations, and taxation of the entire converted amount in the year of conversion.
The IRS has changed the rules in 2010 for Roth IRA conversions by eliminating the $100,000 income limitation and allowing the tax generated by the conversion to be paid over two years (2011 and 2012).
Traditional IRA’s allow a person to put pre-tax money in an account that grows tax free until such time as they withdraw the money and pay tax at the time of withdrawal. A Roth IRA contribution comes from money that has been taxed and also grows tax free. At retirement (at least 59 ½ years old and held for at least five years) the funds may be withdrawn tax free (including the appreciation on the Roth contributions).

Advantages/Disadvantages to Conversion

So why would you want to convert a traditional IRA to a Roth IRA given that you will have to pay tax on the converted amount at your current tax rates? Here are some of the reasons:

• You anticipate being in a higher tax bracket when you would withdraw the funds
• Tax brackets in general will be higher than the current tax brackets
• You have a long time horizon before retirement
• You can pay the tax from funds other than your retirement account
• You do not need the money for retirement and for estate planning purposes you want to pass the tax-free Roth to your heirs.

It makes little sense to withdraw funds from a traditional IRA to pay tax on the conversion to a Roth IRA because not only do you lose the tax-free potential growth on the IRA funds, and, if you are under 59 ½ years old, you would have to pay a 10 percent penalty on the amount withdrawn to pay the tax on the converted amount. Another point to consider is that if your funds to pay the conversion tax have to come from liquidation of appreciated capital assets, then the capital gains tax will increase the cost of the conversion.

Converting a traditional IRA to a Roth IRA is a complex issue that should be examined by each individual based on their particular circumstances as there is no simple answer as to whether it is a good or bad idea. Under the right circumstances, the conversion can be a good opportunity, but it is definitely not right for everyone. The ideal candidate for a Roth IRA conversion is someone who has many working years left before retirement, has assets to pay the tax on conversion that do not come from a traditional IRA or selling capital assets. The conversion may also make sense for those people who have a significant IRA balance that will not be needed in retirement and who want to pass that asset on to their heirs as part of their comprehensive estate plan. If you are seriously considering a conversion of your traditional IRA to a Roth IRA you would be well advised to seek the counsel of your tax and other financial advisors.