With just a handful of weeks remaining, a lot of people are hurrying to perform a Roth IRA conversion in 2010. The last day for Roth IRA conversions in 2010 is December 31. In contrast to traditional and Roth IRA contributions (which can be completed all the way up to April 15 for the previous tax year), conversions need to be completed by 12/31.
Why do you keep hearing so much about Roth IRA conversions in 2010? Before 2010, only people with modified adjusted gross incomes of less than $100,000 could convert. Starting in 2010, this income restriction has been lifted, meaning many more people are eligible to convert their traditional IRAs to Roth IRAs.
Part of this new law is the potential to pay the taxes from any conversions done in 2010 over two years. Rather than having to pay the taxes from the conversion all on one tax return, the IRS is allowing you to pay half in 2011 and half in 2012.
Although the new rules may appear too good to pass up, it is advisable to review your situation carefully before jumping into a Roth IRA conversion in 2010. Just because you can convert to a Roth does not mean you should do a conversion, at least not right away.
Here are some IRA and Roth IRA basics you should be aware of before you determine if a Roth IRA conversion is right for you.
Traditional IRAs
• Money put into traditional IRAs is tax deductible (income limits apply if you are covered by an employer sponsored retirement plan)
• Money taken out of traditional IRAs is taxed at your regular income tax rate, so whatever tax bracket you fall into (15%, 28%, etc.) is the rate you will pay on IRA distributions.
• The IRS requires you to take a minimum amount out (based on your age and the account balance) after age 70 1/2.
Roth IRAs
• Contributions to a Roth IRA are not tax deductible.
• Your ability to contribute to an IRA may be limited if your income is high.
• Qualified withdrawals (must be at least age 59 1/2 and have had the Roth for at least five years) are not subject to income tax.
• Unlike traditional IRAs, you are not required to take money out of your Roth IRA once you reach age 70 1/2
As you can see, there are pluses and minuses to both types of IRAs, so how do you know which one is right for you? Here are some general guidelines to help you determine whether a traditional or Roth IRA makes the most sense for you:
• If you expect to be in a higher tax bracket when you will need the money, then a Roth IRA probably makes more sense.
• If you think you will be in a lower tax bracket when you retire, then a traditional IRA may make more sense as you'll get a tax break up front when your tax rate is higher.
Is a Roth IRA Conversion Right For You?
Please note that when you do a Roth IRA conversion you must pay taxes on the entire amount converted. This is because Roth IRAs are tax-free when you take withdrawals (hey, you gotta pay tax sometime). As a result, your taxes could go up considerably in the year you convert, depending on your other income, how much you convert, and what tax bracket you are in. This can be a substantial tax bill depending on how much you convert and what tax bracket you are in.
Despite the fact that you have to pay taxes on the amount you convert, it may still make sense for some people to convert to a Roth IRA. You should consider converting to a Roth IRA if:
• You expect to be in the same or higher tax bracket when you retire (or when you will need the funds),
• You have a long time horizon for the funds that will be converted, and
• You have funds outside of the IRA to pay the tax resulting from the conversion.
The new Roth IRA conversion rules will benefit a lot of people who didn't have access to Roths previously; however, Roths may not be right for everyone. The people who will benefit the most include people who have been unable to contribute to Roth IRAs due to income limits and people who expect to be in a higher tax bracket when they retire (or who are convinced that tax rates will continue to go up regardless of which bracket you are in).
The bottom line is that just because you can convert to a Roth doesn't mean you should convert. You should consult with a financial or tax professional to determine if a Roth IRA conversion is right for you, since every situation is different. Furthermore, you should evaluate your situation every year as tax rules change each year. A Roth conversion in 2010 might not make sense for you, but a conversion in future years could make sense if tax laws change or your situation changes.
