Now that 2010 is upon us, a significant opportunity is available for individuals. Taxpayers can now to convert a traditional IRA to a Roth IRA, regardless of income level or filing status. This is an exceptional opportunity for many. Here is how it is going to work and what the implications are.
First, here are some basics on a Roth IRA. The Roth IRA contribution is not deductible for tax purposes, so assuming certain age and holding period requirements are met, it is not taxable upon withdrawal. Also, there are no required distributions at any age, so unlike a regular IRA you are not required to begin taking distributions when you turn 70½. At death, there really are no differences as both are still taxed in your estate and a beneficiary has the same distribution requirements from either the Roth or the regular IRA.
Now, let’s look at the conversion of the regular IRA to the Roth. Any part, or all, of your IRA can be converted to a Roth; it doesn’t have to be an all or none situation. However, the conversion does create taxable income which is taxed as ordinary income at your regular marginal rate. Effectively, this accelerates the taxable income that you would eventually have begun once you were 70½ and were required to take distributions from your IRA. However, it does cap the amount you will have to pay tax on. This is significant.
Congress did provide different options to pay the tax on the conversion. You can either pay all of the tax in 2010 or you can average it over 2011 and 2012. However, you will be subject to the applicable income tax rates in 2011 and 2012 so you must consider what effect the applicable tax rates will have on your conversion income. For planning purposes, it may make sense to wait until October of 2011 to file your 2010 tax return. By that time the tax rates for 2011 and 2012 should be published. Then you can decide which year to include the income.
Why would you want to convert to the Roth and pay the tax early? There are many reasons that make this a very important opportunity. Once you meet certain holding period requirements a Roth distribution is tax free, so all earnings and appreciation after the conversion are free from tax. For example, assume that you have a $100,000 IRA that you convert to a Roth. You pay the tax at conversion on the $100,000 (probably $28,000 to $35,000 in tax). If you keep the account for 20 years and let it continue to grow tax free it will be worth about $466,000, assuming an 8% growth rate. However, the tax paid up front would have been worth about $95,000 after 20 years. Effectively, you would have $370,000 net. The additional growth of $366,000 will not be subject to tax and the full balance will be free from tax. That is quite a bargain! Of course, the higher the growth rate on the retirement account, the more benefit there is in converting. Assuming a 15% return, the value of the account in 20 years would be $1,636,000, which means you would receive $1,536,000 tax free. The longer the time horizon, the greater the benefit would be to your family.
Because the Roth does not have the required minimum distribution requirements that a regular IRA does, you will not be required to begin taking distributions from the Roth when you turn 70½ . This will allow the account to continue to grow tax free. This is particularly important for those who do not need the retirement account to live on. You can let it continue to grow tax free and have a tremendous impact on the amount of money you are passing on to your family.
Converting from a traditional IRA to a Roth IRA should be strongly considered in 2010. Advance planning and strategizing should be on your agenda. Contact us and we will assist you in determining if an IRA conversion makes sense for your financial plan.