Is the 2010 Roth IRA Conversion Right for You?

There is an important change in Federal law taking place in 2010 that will allow a one year window for anybody (regardless of income) to convert from a Traditional IRA into a Roth IRA. The details of this change are fairly complicated so I will break it down into the key need-to-know elements.

IRA’s provide tax breaks either up front or when money is withdrawn from the account; money grows tax-free while in both types of accounts. Traditional IRA’s allow you to take an immediate tax deduction on contributions, but you must pay taxes when money is withdrawn. Contributions are not tax deductible with Roth IRA’s but the money can be withdrawn later without paying any taxes on your gain.

Up until this change in law you could only convert an existing IRA into a Roth IRA if you met adjusted gross annual income limitations. Now that the government legislators have temporarily removed these constraints and offered us all the “privilege” of making a Roth Conversion, but does that mean we should take them up on it?

Reasons to Convert

  • You expect Federal tax rates to be higher than they are currently when you will be withdrawing from your account in the future.
  • You expect to be in a higher marginal tax bracket during the years in which you are withdrawing money than you are currently in.

Reasons to Not Convert

  • You expect Federal tax rates to be lower than the current levels when you will be withdrawing from the account. (This is very unlikely considering the dire fiscal situation of the U.S. Government. Taxes are more likely to increase than decrease.)
  • You expect to be in a lower marginal tax bracket during the years in which you are withdrawing money than you are currently in.

Important Issues to Consider

  • If you convert in 2010, you have the option to pay the taxes immediately in 2010, or split the payment of taxes  over 2011 and 2012. However you would be required to pay whatever the current rate is, which may be higher if congress raises taxes. Depending on the size of any tax increase, this may cancel out any positive effect of converting and may cause you to pay more taxes than necessary.
  • If you earn more in the future and end up in a higher tax bracket during the time you will be withdrawing money, you may have been better off not converting.

Conclusion
Due to uncertainty regarding future Federal tax policies, converting to a Roth IRA is likely to be less beneficial for most people than it would seem on the surface.  In general, a Roth conversion makes the most sense for:

  • Young individuals in low tax brackets who are beginning their careers
  • Semi-retired or retired individuals who will not be withdrawing from their accounts who currently qualify as low income
  • High net worth individuals that would be subject to estate taxes.

For people converting, t would also be advisable to pay all taxes in 2010 rather than deferring them because of the likely possibility that the government will raise tax rates for 2011 and 2012.

It is very likely that the Feds are simply using this change to try accelerating tax revenues, however, there are still some cases where a conversion makes sense. If you think a conversion might make sense for you, please feel free to give me a call or send an email with any questions you may have about your specific situation.

All the best,

Michael

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