For certain individuals, converting a traditional IRA to a Roth IRA may provide advantages from an income tax and estate planning perspective. Previously, eligibility to convert to a Roth IRA was prohibited for those with household income over $100,000 (as measured by modified adjusted gross income).
Rule changes have created a friendlier environment for those wishing to convert their IRA to the Roth format. Specifically, starting in 2010 and beyond, anyone with a traditional IRA can convert all or a portion to a Roth IRA, regardless of their level of household income.
The conversion process is a taxable event with the dollar amount converted being considered ordinary income, added to your other sources of income when determining your federal tax liability (and potentially state tax liability depending on your state of residence). Previously, the tax owed from a Roth conversion was due all at one time, typically by April 15 of the year following the year of the conversion when you file your federal return.
The rule change contains a provision allowing for the amount converted to a Roth IRA to be recognized as income either all at once, or spread equally over the tax years of 2011 and 2012. This can be an important advantage for those who may not be prepared to pay the conversion tax all in one year as we will cover now in the decision process.
The most important question is why convert and pay the tax? Qualified distributions from Roth IRA’s, generally taken in retirement are not considered taxable income, unlike distributions from traditional IRAs which are added to income for calculation of federal tax liability. Obviously, the conversion process requires you to pay the tax on the converted amount in the next few years, so there has to be some longer term benefit to make it worth paying the tax in the near future. There are several potential benefits from converting, and I suggest consulting your tax or financial advisor to see how these benefits may work in your favor.
1. Potential for lower taxable income in retirement.
2. Roth IRAs can be left to heirs in their entirety, with withdrawals being tax-free.
3. Potential for additional accumulation during your lifetime with no required minimum distributions.
Of course, these potential benefits need to be weighed against the up-front tax cost of converting. Conversion calculators designed to illustrate the benefits or disadvantage of converting are available at many brokerage firm and mutual fund company Web sites.
While each individual situation should be reviewed to determine if a full or partial conversion is in your best interest, there are a few guidelines which can generally be helpful in deciding whether to investigate a conversion more fully.
First – Can you pay the conversion tax from a source other than IRA funds? There are almost no cases where paying the tax from within your IRA make the conversion worthwhile and generally have a negative impact.
Second – Do you anticipate at least 10 years before utilizing the funds within the converted Roth IRA to support your lifestyle, or do you intend not to touch the Roth IRA at all and leave it to heirs? The tax cost requires time to overcome and the breakpoint is generally about 10 years even when the tax is paid from outside the IRA.
If the answer to these primary questions is yes, then it is worth investigating a conversion further. Of course, obtaining qualified advice is a good idea in these matters.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. www.breitercapital.com.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing.