Q: Someone mentioned a Roth IRA conversion to me. I’m not really sure how it works and if it makes sense for my retirement. Can you please help?
A: In 2010, the rules for Roth IRA conversions changed, which may be a good thing for you. Let’s explore some of the factors that may affect your decision to convert assets within a traditional IRA to a Roth IRA, as well as the potential benefits and tax implications of a conversion.
Until recently, retirement investors who wanted to convert all or a portion of their traditional IRA account balance to a Roth IRA faced a stumbling block: According to old IRS rules, conversions were available only to those with modified adjusted gross incomes (MAGIs) of $100,000 or less. But in 2010, this restriction was removed, permitting retirement investors at any level of income to convert assets from a traditional IRA to a Roth IRA.
Whether you should convert all or a portion of your traditional IRA assets to a Roth account may depend on the amount of time you plan to leave the assets invested, your estate-planning strategies and your willingness to pay the federal income-tax bill that a conversion is likely to trigger.
Two types of IRAs: Traditional & Roth
Each type of IRA has its own specific rules and potential benefits.
Traditional IRA — Maximum annual contribution: $5,000 for single taxpayers for 2011. An additional $1,000 “catch-up” contribution is permitted for each investor age 50 and older who has already made the maximum annual contribution. — Income thresholds for annual contributions: None, as long as the account holder has taxable compensation and is younger than age 70-and-a-half by the end of the year. — Deductibility of contribution: Yes, if account holder meets income requirements established by the IRS. — Contributions after age 70-and-a-half: Not allowed. — Required minimum distributions (RMDs) after age 70-and-a-half: RMDs are required. — Taxes on distributions: Qualified distributions are taxed as ordinary income. Withdrawals before age 59-and-a-half may also be subject to a 10-percent penalty. (Check irs.gov or consult your financial advisor.)
Roth IRA — Maximum annual contribution: Same as traditional IRA: $5,000 for single taxpayers for 2011. An additional $1,000 “catch-up” contribution is permitted for each investor aged 50 and older who has already made the maximum annual contribution. — Income thresholds for annual contributions: Single taxpayers with MAGIs in excess of $122,000 are not eligible in 2011. Income thresholds are indexed annually. — Deductibility of contribution: No. — Contributions after age 70-and-a-half: Contributions allowed after age 70-and-a-half if owner has earned income. — Required minimum distributions (RMDs) after age 70-and-a-half: Not required. — Taxes on distributions: Qualified distributions are tax-free. Withdrawals from accounts held less than five years or before age 59-and-a-half may be subject to taxes and a 10-percent penalty. (Check irs.gov or consult your financial advisor for more information.)
Conversion: Potential benefits ...
Potential benefits of converting from a traditional IRA to a Roth IRA include:
— A larger sum to bequeath to heirs. Since RMDs are not required for Roth IRAs, investors who do not need to take withdrawals may leave the money invested as long as they choose, which may result in a larger balance for heirs. After an account owner’s death, beneficiaries are required to take distributions, although different rules apply to spouses and non-spouses.
— Tax-free withdrawals. Even if retirees need withdrawals for living expenses, withdrawals are tax-free for those who are age 59-and-a-half or older and who have had the money invested for five years or more.
... As well as a potential drawback
— Investors who convert from a traditional IRA to a Roth IRA are required to pay income taxes at the time of conversion on investment earnings and any contributions that qualified for a tax deduction. If you have a nondeductible traditional IRA (i.e., your contributions did not qualify for a tax deduction because your income was not within the parameters established by the IRS), investment earnings will be taxed but your contributions will not. The conversion will not trigger the penalty for early withdrawals.
Factors to consider:
— A conversion may be better the further you are from retirement. The longer your earnings can grow, the more time you have to compensate for the associated tax bill.
— Your current and future tax brackets will affect which IRA is best for you. If you expect to be in a lower tax bracket in retirement, sticking with a traditional IRA could be the best option because your RMDs during retirement will be taxed at a correspondingly lower rate than amounts converted today. On the other hand, if you anticipate being in a higher tax bracket, the ability to take tax-free distributions from a Roth IRA could be a benefit.
There is no easy answer to the dilemma of converting a traditional IRA asset to a Roth IRA. As with any major financial consideration, careful consultation with a professional is a good idea before you decide.
This article was prepared with the assistance of McGraw-Hill Financial Communications and is not intended to provide specific investment advice or recommendations for any individual. Consult your financial advisor or Jeremy Gussick if you have any questions. LPL Financial, Member FINRA/SIPC. *Based on total revenues, as reported in Financial Planning Magazine, June 1996-2010. **Details on the award can be found at www.fivestarprofessional.com.