The 2010 Roth IRA Conversion Opportunity

Since last spring, I’ve covered all of the steps involved in financial planning and portfolio management. Now, with only a few months left in the year, it’s time to focus on some specific strategies to ensure your money continues to work hard for you in 2010 and beyond.

One topic you’ve probably already read about are the changes surrounding Roth IRA conversions in 2010. Since its inception in 1998, the Roth IRA has provided taxpayers with a powerful savings tool that enables them to eventually make tax-free withdrawals. Unfortunately for higher income taxpayers, the IRS instituted income limits that not only prevented them from making Roth contributions, but also restricted them from converting existing traditional IRAs into Roths.

Some of that changes next year. The Roth IRA contributions income limit remains in place, but a new U.S. tax law allows any taxpayer, regardless of income, to convert all or part of their existing tax-deferred accounts into tax-free Roth IRAs. So, now that you can convert, the question becomes should you? with an adjusted gross income limit of $176,000 for married couples, and $120,000 for singles, the Roth has been unavailable to higher income taxpayers. That will soon change. While high income earners will still be restricted from making new Roth IRA contributions, in 2010 they can convert all or part of the money they’ve saved over the years in traditional IRAs and 401(k)s into a tax-free Roth IRA. A new U.S. tax law has eliminated the $100,000 adjusted gross income threshold previously used to limit Roth IRA conversions.

Roth IRAs certainly have some compelling qualities:

• They have tax-free withdrawals as long the Roth has been held for five years and the account owner is 59 ½.
• Unlike traditional IRAs, there are no required minimum distributions for account owners who are 70 ½ or older. This allows for greater control of your income tax liabilities in retirement.
• In some cases, a Roth IRA may be an effective estate planning tool. Payment of income taxes at conversion has the potential to reduce estate taxes and increase the after-tax inheritance to your beneficiary.
• If a converted IRA decreases in value, you may have the option to “un-do” the conversion prior to your next tax filing deadline.

While converting to a Roth offers many advantages, it may or may not make sense depending upon upon how muchthe impact the conversion will have on your income and your taxeswill cost and on future tax rates. The current value of all pre-tax contributions and earnings included in your Roth conversion amount is treated as ordinary income. This may bump you into a higher tax bracket, and may even force you to pay the Alternative Minimum Tax. Also, Taxes are due when a traditional IRA account is converted to a Roth because the current value of all pre-tax contributions and earnings included in the conversion amount is treated as ordinary income. The account owner must pay income taxes on the applicable conversion amount. For example, if a taxpayer in the 28% federal tax bracket converts $100,000 of pretax dollars to a Roth IRA, he or she would pay $28,000 in federal taxes, plus the appropriate state amount. However,The good news is the IRS will allow taxpayers to pay this liability equally across the 2011 and 2012 tax years, easing the burden somewhat.

Still, for investors with six-figure or seven-figure traditional IRAs or 401(k)s, the tax liability of a total conversion could be substantial. Investors should also think about whether it makes sense to convert and pay taxes today at a higher rate when they could possibly be in a lower tax bracket during retirement. For example, if you are a high wage earner and are in the 33% bracket, you will pay that percentage when converting. If you are confident you will be in a lower tax bracket during retirement, it may pay to keep your traditional IRAs into your golden years and pay the lower rate upon making withdrawals. Another issue to consider is the possibility that the federal government will change the tax code in the future, potentially making Roth IRAs less advantageous. Nevertheless, Roth IRAs have some compelling qualities: Tax-free withdrawals as long the Roth has been held for five years and the account owner is 59 ½. Unlike traditional IRAs, there areis no required minimum distributions for account owners who are 70 ½ or older. This allows for greater control of your income tax liabilities in retirement. In some cases, a Roth IRA may be an effective estate planning tools. Payment of income taxes at conversion has the potential to reduce estate taxes and increase the after tax inheritance to your beneficiary. If a converted IRA decreases in value, you may have the option to “un-do” the conversion prior to your next tax filing deadline.

Given the number of advantages, costs and unknowns surrounding the question of converting, another option would be for investors to only convert part of their traditional IRA holdings into Roth IRAs. By owning both types of IRAs, investors can build a more tax-efficient, more diversified portfolio, by reaping some of the Roth’s benefits while protecting themselves from unknowns such as without worrying about retirement tax brackets or the government changing the tax codewhich tax bracket the account owner might be in during retirement. or the government changing the tax code, Roth IRA rules or both.

With proper planning, this tax law change has the potential to provide investors with tax-free income, more diversified portfolios, greater choice regarding when to take distributions, and additional estate planning options. Yet, the issues surrounding conversion are complicated and decisions should be made on a case-by-case basis in consultation with your tax professional.