Thursday, January 07, 2010

2010 Roth IRA Conversion – To do Or Not to Do

By Rajiv Hargunani

Rajiv Hargunani is an independent Financial Advisor based in Birmingham, AL working at Raymond James Financial Services. Rajiv specializes in wealth management with an emphasis on risk management & asset protection for his clients. He helps small businesses set up retirement plans such as 401(K), SIMPLE IRAs, SEPs and takes an active role in educating the employees so they can make solid informed retirement planning decisions. His financial planning philosophy is really very simple: Plan, Communicate & Perform. He can be reached by phone at (205)939-0100, (205)541-7438 (Cell) or by email at .(JavaScript must be enabled to view this email address)

In a few months something very exciting is about to change the world of retirement planning. I am talking about the Roth IRA Conversion. Roth IRAs have always been an attractive vehicle for retirement savings given their primary benefit of tax free distributions. However, if you were a high-income earner, most likely you were unable to contribute to a Roth IRA. Well, that’s about to change in 2010, thanks to the Tax Increase Prevention and Reconciliation Act signed in 2006, anyone regardless of their income or filing status will be able to convert their traditional IRA to a Roth IRA.

Here is a brief description of the traditional & Roth IRA

Traditional IRA- In most cases, the money that is contributed to the traditional IRA can be deducted from your taxes. The exception being if you are covered by a qualified retirement plan from your employer such as a 401(K) in which case your deduction could be phased out depending on your income and filing status. The distributions from the traditional IRA are taxed at ordinary income tax rates and you have to take a minimum distribution starting at age 70 ½.

Roth IRA – In this case, contributions are made with after-tax dollars, and the distributions are tax free as long as you have the IRA for at least 5 years and you are at least 59 ½ years old. There is no mandatory requirement to take the money out at any age. Not everybody is qualified to contribute to the Roth IRA. Contributions to the Roth IRA depend on your filing status and income.

For more detailed information on the IRAs, check out publication 590 available at the IRS website: http://www.irs.gov/pub/irs-pdf/p590.pdf
Few benefits to consider when converting to the Roth IRA next year:

1. Although the income limitation to convert a traditional IRA to the Roth goes away in 2010 (and beyond), the biggest benefit of doing the conversion next year is that the tax burden can be shifted to the 2011 & 2012 tax return years. This has the advantage of reducing the burden of paying all the taxes in the year of the conversion.

2. Another huge benefit is in the area of estate-planning. Let’s say you have a large balance in your IRA that you may not need over your lifetime and say you want to leave your money to your kids or grandkids. The beneficiaries will pay no income tax when they take withdrawal from the inherited IRA. However, they may have to withdraw a minimum amount (tax free) every year based on their life expectancy, but the rest of the money will continue to grow tax free.

Few questions that may help you determine if you should convert or not:

1. How are you going to pay taxes on the conversion?
Tapping into the Traditional IRA to pay the tax burden makes no financial sense. If you are below the age of 59 ½, the IRS will levy a 10% penalty on the amount used to pay the taxes. Additionally, the huge benefit of compounding is lost forever on the dollars that were used to pay the taxes.

Finally, if you have resources outside the IRA to pay the conversion tax, you have to take into account the “opportunity cost” of what the money may have earned had it remained in an investment account.

2. How long before you are going to retire?
If you are starting out in your career and believe your highest earning years are ahead of you, the Roth Conversion can be particularly attractive.

3. What will be your income tax bracket at or during retirement?
The answer to this question will be at the heart of the decision you will make. If you are say in the 35% tax bracket now and expect to drop to a much lower tax bracket, then it does make sense to go with the conversion right now. You would rather let the money grow in the traditional IRA or 401(K) and take out the money at the reduced rate in the future. However, if you believe the tax rates will be going up or you will be in a much higher tax bracket, then the decision to convert to the Roth IRA will be more favorable.

Summing it up, the conversion to the Roth IRA has potential for significant benefits if the circumstances are right for you. Remember, every situation is different and has to be evaluated on its own merits. Please be sure to talk with your own Financial and Tax Advisor to determine if converting to the Roth IRA makes financial sense for you.

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