Individual Retirement Accounts (IRAs) are a great retirement savings tool for most individuals. They come in two types: Traditional and Roth. Traditional IRAs are established with pretax dollars and you will pay income tax on the full amount when you withdraw the money. Roth IRAs (named after Senator William Roth of Delaware) are established with after tax dollars and your money will grow tax free. This means you will not pay income taxes when you take your money out of the account.
IRA conversions are a great opportunity for those who can benefit. What is an IRA conversion? The IRA conversion process is moving your money from a Traditional IRA to a Roth IRA. The downside is that you are required to pay income taxes on the converted dollars at conversion time, but your money will grow tax free.
Prior to 2010, there has been a $100,000 Adjusted Gross Income (AGI) limit. This meant that anyone, single or married, with AGI limit over $100,000 was not allowed to convert from a Traditional IRA to Roth IRA. Now for calendar year 2010 only, the laws have been changed to allow anyone to convert a Traditional IRA to a Roth IRA.
Advantages to Converting to a Roth IRA:
- Avoid Taxes in the Future: Roth IRAs grow tax free. Therefore there will not be any taxes owed when you decide to withdraw your money.
- No Required Minimum Distributions (RMD): Roth IRAs do not require RMDs after age 70 ½, so your money can continue to grow with the potential for larger dollar amounts to leave to heirs.
- Lower Balances to Convert: Due to the recent market downturn, most people have lower balances which mean there will be less taxes paid on the conversion.
- Spread Taxes Over Two Years: The federal government is also allowing income tax due on your 2010 conversions to be split between 2011 and 2012.
Prime Candidates for Roth IRA Conversion:
- People who think they will be in a higher income tax bracket in the future. Since Traditional IRAs require RMDs and RMDs are taxed at your marginal tax bracket, then it is better to pay taxes now on the converted amount than pay taxes in retirement.
- Younger individuals will have more time to recoup income tax payments on the conversion. The quicker you reach the break even point the better off you will be.
- If you think you will not need the money for retirement, then the conversion allows you to not take RMDs.
Individuals Who Should Think Twice:
- If you do not have the money to pay the income taxes on the converted amount, then converting to a Roth IRA is probably not a wise choice.
- If you think you will in a lower tax bracket in the future, then leave your money in your Traditional IRA and pay the taxes on future RMDs.
If a do-it-yourselfer, be sure and check IRS Publication 590 (Individual Retirement Arrangements) because it will explain the finer details about conversions. Or, consult with a tax specialist or financial advisor to help you with details and to avoid any overlooked requirements. Check out all options and see if the Roth IRA conversion is a good idea for you.
Kimberly J. Howard, CFP®, CRPC® is a Certified Financial Planner and the owner of KJH Financial Services, a Fee-Only practice located in Needham, MA (781-413-4879). Please visit us at www.kjhfinancialservices.com or email Kim at firstname.lastname@example.org.