Beginning in 2010, investors converting assets from a traditional IRA to a Roth IRA are no longer limited by a $100,000 modified adjusted gross income cap. So now that you can convert, the new question becomes should you convert. The answer depends on a large number of variables, some of which require some educated guesses about the future of the tax system and your own situation.
With a Roth IRA, you have to pay taxes on income now, invest that income and pay no taxes on your contributions or the earnings when you withdraw them. A traditional IRA works in reverse: you contribute pre-tax dollars or receive a tax deduction now, and pay taxes on your withdrawals when you take them. Your decision to convert depends in part on your expected tax bracket after retirement. If you believe your tax level will be higher in the future than it is today, it may make sense to pay those taxes now with a conversion. If you expect your tax level will be lower in the future, a conversion may not be in your best interest as you would pay more taxes by converting today than you when you withdraw those assets from a traditional IRA in the future.
Your traditional IRA may have been funded with both nondeductible contributions (you already paid taxes on them) and deductible contributions (you have not paid taxes on them or received an equal tax deduction). If you convert nondeductible IRA contributions, you will pay taxes only on the earnings. If you convert deductible contributions, you will owe taxes on the contributions or earnings, resulting in a significant tax hit at the time of conversion. The law allows you to split the income realized in 2010, half into 2011 and half into 2012. Each half of the income is taxed at that year’s rates, along with any other income normally realized for those years. You also have the option of making a special election and report the income in 2010, which may be beneficial if the tax rates are higher in 2011 and 2012.
You can make a partial conversion of your traditional IRA to a Roth IRA. For example, if your nondeductible and deductible contributions have been segregated into separate traditional IRA accounts, you can choose to convert only the accounts holding nondeductible contributions.
If paying the tax bill on your deductible contributions will require you to take a withdrawal from the account, a conversion may not be in your best interest, especially if you are under age 59 1/2 and subject to the 10 percent early withdrawal penalty. In addition, you will be reducing the amount that can grow tax-free in the Roth IRA.
The younger you are, the harder it is to predict tax rates and other factors that may impact your retirement. On the other hand, younger investors typically have longer to allow their Roth IRA assets to compound tax-free. A Roth IRA conversion may not be appropriate if you are near retirement and expect to need the assets in your IRA soon after you retire, as you will have less time for the assets to earn an amount comparable to your tax hit at conversion.
Your decision to convert or not convert will depend on the many factors of your individual situation today and your beliefs about your situation in the future. Your tax and investment professionals can provide important guidance and analysis.
Kris Flammang, a co-founder of LPF Financial Advisors with offices in Lakewood Ranch, is a chartered retirement planning counselor and registered representative with Securities America, Inc.Member FINRA/SIPC. He can be reached at (941) 907-0101 or firstname.lastname@example.org.