Traditional to Roth IRA Conversions

Four years ago, the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) relaxed some restrictive rules preventing many taxpayers from converting a traditional IRA to a Roth IRA, but this favorable change was not effective until 2010. Well, 2010 is almost here and the old saying "good things come to those who wait" is certainly true in this case. This article will explain why the timing for this rule change could not have been better.

Roth IRAs offer benefits not available with a traditional IRA. First, earnings are distributed tax-free if basic Roth requirements are satisfied. Next, owners are never required to take distributions during their lifetime, so earnings can continue to compound for the benefit of the beneficiary. Finally, contributions can be made after age 70 1/2 for additional tax-free growth.

Prior to TIPRA, traditional IRA owners could convert their account to a Roth IRA, pay any taxes due from the conversion, and receive Roth IRA benefits going forward. There was, however, a major obstacle for many taxpayers. The conversion privilege was only available when the taxpayer making the conversion had modified adjusted gross income of $100,000 or less. TIPRA removed this restriction beginning in 2010, and also provided that any taxes due on 2010 conversions could be paid one-half each in 2011 and 2012.

Now let's discuss the timing aspect of the new rule for you patient investors considering a Roth conversion. If your traditional IRA has dropped in value and you expect to pay higher federal income tax rates in future years, now might be a very good time to consider converting all or part of your traditional IRA balance into a Roth IRA. Here's why. If you convert, it will likely trigger a current tax hit on the taxable portion of the amount of your conversion. But, with your traditional IRA balance at a somewhat lower level than in previous years (and possibly your overall income, too), the tax hit will be less. Then, after the conversion, your new Roth IRA balance can build up federal-income-tax-free. Eventually, you can take tax-free withdrawals (not required) when your marginal tax rate may be higher (perhaps much higher) than it is right now. So, that means less taxes now with your conversion and no taxes on your future distributions. Your patience has paid valuable dividends!

Reverse an Ill-advised Roth Conversion. Another great thing about the Roth conversion strategy is you can always change your mind well after the fact. Believe it or not, you have until October 15 of the year following the conversion year to recharacterize (unwind) your converted account (or accounts). For example, say you convert a traditional IRA into a Roth account in early 2010. Later next year, the value of the converted account plummets due to poor performance of the investments held in the account. In this bleak scenario, you would pay income tax on value that later disappeared. Bad idea! Thankfully, you have until October 17, 2011 (October 15, 2011 is a Saturday), to recharacterize the converted account back to traditional IRA status. It's as though the ill-advised conversion never happened. So, you won't owe any income tax on the now-unwound conversion.

Conclusion. Low current tax cost for converting plus the chance to avoid higher future tax rates on income and gains that will accumulate in your Roth account as the economy recovers (we hope) may add up to the perfect storm for the Roth conversion idea. That said, please contact us prior to pulling the trigger. There are a number of variables to consider, and we would welcome the opportunity to work with you to ensure a well-informed and thoughtful decision.

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