Deciding About a Roth IRA Conversion

Before you know it, the end of the year will be here. For many individuals contemplating a conversion from a traditional IRA to a Roth IRA, it is time to make some critical decisions.

Key rules: Distributions from a traditional IRA are generally taxed at ordinary income rates currently reaching as high as 35%. (Future tax rates are currently scheduled to rise.) The taxable portion includes earnings within the tax-deferred account and amounts attributable to deductible contributions.

Conversely, “qualified distributions” from a Roth IRA are completely tax-free. A qualified distribution is one from a Roth in existence for at least five years that is made after you have reached age 59½; upon death or disability; or to pay for first-time homebuyer expenses (up to a lifetime limit of $10,000). Other distributions are treated as coming first from Roth IRA contributions, second from amounts transferred to the Roth and third from earnings.

In effect, a conversion of assets from a traditional IRA to a Roth is treated as a withdrawal for tax purposes. So you are generally required to pay the usual amount of tax when you convert.

But the current tax cost may be worth it in exchange for future tax-free distributions. Furthermore, unlike a traditional IRA, you don’t have to take minimum distributions from a Roth after age 70½.

What has been holding you back? Prior to this year, a conversion was not allowed in a year in which your modified adjusted gross income exceeded $100,000. However, beginning in 2010, this restriction has been removed. Therefore, high-income individuals may be eligible to convert to a Roth for the first time. Another incentive: For a conversion in 2010—and 2010 only—you can choose to have the taxable income from the conversion split evenly over the following two years—2011 and 2012.

But there are potential drawbacks. For instance, if you have to use funds from your IRA to pay the resulting tax, converting will likely dilute future benefits. Also, you might not choose the two-year tax deferral if you expect to be in a low tax bracket this year or in higher tax brackets in the future. Some other factors include

  • Your age, your spouse’s age (if married) and the ages of the beneficiaries
  • The value of the assets in your IRA
  • The need to receive Roth IRA distributions in the future
  • The projected investment rate of return
  • Any state and local tax implications
  • Any nondeductible contributions to traditional IRAs

This requires a careful analysis. Be wary of online calculators that leave out any of the critical factors.

If it suits your purposes, you might opt for a partial conversion. Obtain expert guidance from your professional advisers.