Monthly Q & A

Is a Roth IRA Conversion opportunity best for you?

2010 is the year of the Roth IRA conversion. But is a Roth right for you?

A change in federal law has eliminated income limits for eligibility to convert traditional tax-deferred retirement savings to Roths. As a result, mutual funds and financial advisers are marketing conversions this year with gusto.

Unlike a tax-deferred retirement account, you contribute post-tax dollars to a Roth IRA–but your Roth grows tax-free thereafter. With a traditional IRA, you’ll pay taxes upon withdrawal on both the original investment and any growth. So for many investors, long-term returns from the tax-free Roth will be substantially higher than with a traditional IRA.

Another major Roth benefit is flexibility. You must take an annual distribution from your traditional IRAs once you turn 70-1/2, but these aren’t required with a Roth. If you don’t need the funds to meet living expenses, you can let the invested funds keep growing. This feature also makes Roths a good vehicle for estate purposes, as you can bequeath holdings to heirs as tax-free income.

But Roth conversions do present some tricky issues. Here’s the big one: Assets converted from tax-deferred to Roth accounts are taxed as ordinary income. You have three ways to pay the tax bill: use separate taxable account, pay it from your traditional IRA or make a withdrawal from your new Roth IRA.

Using assets in a separate taxable account to pay the taxes due on the conversion amount allows you to maintain the largest amount in your tax-deferred accounts — namely, in your traditional IRA or Roth.

If you pay the taxes due by withdrawing additional assets from your traditional IRA, you will reduce the amount still held in your traditional IRA even further–but you’ll be able to maintain whatever balance you have in taxable accounts for other purposes.

If you withdraw assets to pay the conversion taxes from the Roth IRA you just created, you’ll protect more of the assets remaining in your traditional IRA and the assets in your taxable account. Using the Roth-converted funds doesn’t generate additional tax–but the amount you withdraw would be subject to a 10 percent early withdrawal penalty if you’re under age 59-1/2.

If you convert in 2010, your friends at the federal government have created a convenient option on tax payments. You can include the taxable portion of the conversion on your 2010 income tax return, or you can push the taxable amount out — in equal shares — to 2011 and 2012 , respectively. If you take that option, you’d pay taxes on the conversion on your tax returns for 2011 and 2012.

Keep in mind that your tax rate may be approximately 10 percent higher when those bills come due, since the Bush-era tax cuts are set to expire at the end of this year. The Obama Administration has pledged to increase tax rates for individuals earning more than $200,000, and married couples earning $250,000 or more, while keeping the current rates in place for people below those thresholds–at least for the time being. But the tax outlook is uncertain.

Tax traps: Also, the sudden bump in income from a Roth conversion can trigger tax costs you may not have considered. IRA expert Ed Slott noted in a recent edition of his IRA Advisor newsletter that some Roth conversions can lead to higher Medicare Part B premiums for some investors. Part B premium rates are tied to income; in 2010, it’s $96.40 per month for Medicare recipients with income of $85,000 or less ($170,000 or less for joint filers). Above that income level, Medicare premiums rise and are tied to brackets of income.

Slott also noted that Roth conversions can cause problems for parents relying on financial aid for their kids’ college tuition. Most colleges don’t count tax-deferred retirement assets in their aid formulas, but the ordinary income generated by a Roth conversion might well be eligible and could result in lost financial assistance in the year where that income is recognized.

Should you do a Roth conversion now? That depends on whether you believe tax rates are going to fall or rise in the future? In addition, have you considered all of the tax free options that are available? Answering these two quesitons will be the first step to determining if you are prepared to look into a conversion or a tax-free option going forward.

The best conversion candidates are investors who can fund the tax liability from their taxable assets, don’t expect a significant drop in their effective tax rate in retirement and are converting at younger ages, according to a Roth analysis by Bernstein Global Wealth Management. You’ll also get the best kick from a Roth if you don’t expect to draw heavily from your IRA in retirement and aim to transfer your IRA at death to your beneficiaries.

A final point: The basics of Roth conversion aren’t complicated but they can present some complex choices and tax implications. If you’re going to convert, it’s best to get some expert advice–based on your personal situation–from an accountant or financial adviser. Contact True Wealth Advisory Group today and we will help you to find further answers to your investing questions.