The year 2010 presents a unique opportunity for retirement savers as a result of the Tax Increase Prevention and Reconciliation act of 2005 (TIPRA). Provisions within TIPRA allow many more retirement investors the option of converting a traditional IRA or eligible workplace plan account to a Roth IRA. The income limitations which prohibited many retirement investors from converting in past years have been removed. Married taxpayers who file separately are now allowed to convert. And as if that wasn’t enough, the IRS will allow you to defer the tax liability on the amount converted in 2010 equally over the following two years…2011 and 2012. So what is involved in a Roth conversion and why should you consider it? Well, please read on to learn more about the benefits and drawbacks to converting.
Why Convert Now?
Why would someone convert a Traditional IRA to a Roth IRA? Essentially you are making a deal with the Internal Revenue Service to pay taxes on your retirement plan now in exchange for tax-free growth of your retirement plan. Depending on how much time you have until you need to access your retirement funds this can be an incredible benefit. Remember that IRA funds cannot be tapped prior to age 59 ½ without paying the IRS a 10% early withdrawal penalty. And after you reach age 59 ½ whatever funds drawn out of your IRA are taxed at the ordinary income rates at that time. Let’s take a look at a simple example. Suppose you are 30 years old and you have $100,000 dollars in your IRA. By the time you reach age 70 ½ your Traditional IRA may have grown to $500,000 and you are required to begin making mandatory distributions which are taxed as ordinary income. We have no way of knowing what income tax rates will look like 40 years from now so let’s assume rates are equal to the highest marginal rate currently. If that is the case then 35% of every withdrawal taken after age 70 ½ goes to pay taxes. If you were to withdraw the entire $500,000 in one year your tax liability would be $175,000.
Now, suppose that same 30-year old decides to convert the $100,000 traditional IRA to a Roth IRA in 2010. Assuming our 30-year old friend is in the highest tax bracket now our sample person would have to pay $35,000 in taxes. Because of the TIPRA legislation the tax liability on the conversion would be $17,500 in 2011 and $17,500 in 2012. The decision then becomes simple mathematics…would you rather pay $35,000 now or $175,000 later on. The correct choice for the 30 year old is obvious, but what if you are in your 40’s, 50’s, 60’s, 70’s or 80’s?
Is it a Good Decision for your Circumstances?
As you make your way towards retirement age or perhaps you are already there the decision of whether or not to convert is considerably more complicated and warrants a lengthy discussion with your financial adviser and CPA. The benefits of converting to a Roth IRA in the later stages of life might be greater for your heirs than they are for you. For example, a Roth IRA does not require mandatory distributions at age 70 ½ like a Traditional IRA. If you are fortunate enough to have more funds invested in your IRA than you will need in your lifetime then converting a portion of those funds to a Roth IRA can be a great estate planning tool. With no mandatory distribution requirements the funds invested in a Roth IRA can grow tax-free long after you have attained age 70 ½ . Both Traditional IRA and Roth IRA assets are subject to estate taxes at the death of the owner when there is a non-spouse beneficiary. The advantage to the beneficiary of the Roth IRA is tax-free withdrawals from the account as long as the Roth IRA has been in existence for 5 years. The beneficiary of a Traditional IRA will have withdrawals subject to ordinary income tax.
For those that have been unable to convert to a Roth IRA in years past (maybe because of income limitations) 2010 offers a wonderful opportunity to do so. There are several software packages and online calculators that your financial professional can utilize with you to determine the best scenario for your situation. Talk with your adviser soon to determine your action plan for 2010 and whether or not a Roth IRA conversion is right for you. |
