In the final installment of my three-part series on end of the year planning, I will discuss the very important and attractive opportunity to convert a traditional IRA to a Roth IRA. While this opportunity may not necessarily apply to everyone, a conversion is certainly worth considering before the end of 2010.
One of the most attractive tax planning options that is only available for the 2010 tax year (unless extended) is converting a traditional IRA to a Roth IRA, and spreading the tax liability over the 2011 and 2012 tax years. For example, if the traditional IRA account owner converts their IRA to a Roth before year-end 2010, they can spread the tax liability over the 2011 and 2012 tax years, meaning you can pay half on April 15th, 2012, and the other half on April 15th 2013 (you can pay the taxes in 2010, or all of more than half in 2011, etc, if you wish). You will still have to pay ordinary income tax on the value of the proceeds you take out of your traditional IRA, except for any contributions you have made with after-tax money. This tax deferral option makes the conversion much less painful. In years past, there was a $100,000 adjusted Gross Income limit on conversion, but there is no limit for conversions in 2010.
One thing to keep in mind is that, if you convert, you will not want to use proceeds from the traditional IRA to pay the taxes, if you are younger than age 59 ½, because you will incur a 10% penalty for early withdrawal. You don’t have to convert the entire amount in the traditional IRA to the Roth, (although you can). You can choose to convert any portion of a traditional IRA to a Roth IRA, and can maintain the traditional IRA with whatever balance you choose to leave in the account. You can also convert more than one traditional IRA (or all of them) into a Roth.
You will want to review your 2010 tax liability and understand if converting will push you up into a higher bracket. In this case, you may want to convert only that portion of the traditional IRA that will allow you to take advantage of this opportunity without increasing your tax bracket. Also keep in mind that you cannot avoid the conversion tax by just rolling over an amount equal to your after-tax (nondeductible) contributions. Each dollar you roll over from a regular IRA is considered a "blended" dollar. Therefore, a percentage of the amount rolled over into the Roth account will be taxed unless your IRAs are worth less than the amount of your after-tax contributions).
Keep in mind that, if you have multiple IRAs, you will be required to pull equally from all IRA accounts, so that the tax liability on each dollar converted is the same. In other words, you can’t pick and choose which assets within the traditional IRA you want to convert, and only choose those, for example, that are down in value to reduce your tax liability.
The reason a Roth makes so much sense, particularly for younger investors, is that all growth and future disbursements will be tax-free. In other words, once you have paid the taxes on the conversion, you will not have to pay any taxes on any profits you make in the Roth account, or on any money you withdraw from the Roth (after age 59 ½ and as long as you have had the money in the Roth for at least 5 years). So, the younger you are, in general, the more sense converting makes.
Another reason to consider converting is that, if you feel you will be in a higher tax bracket in the future, either because you think tax rates will rise (they probably will after 2012), or because your income will be higher, converting now may allow you to pay a lower tax rate on the money that is currently in your traditional IRA.
Another benefit of converting now is that, if you believe the stock market still has room to rise in value over time from where it is now (and assuming you are holding stock investments in the IRA), converting now will mean paying less in taxes because the market is lower today and therefore your account value is lower than it will be in the future.
Even if you are older, a Roth still may make sense. Normally with an IRA, at age 70 ½ you are required to withdraw from your IRA through mandatory required distributions. However, with a Roth, there is no mandatory withdrawal rule allowing you more time for the account value to grow tax-free. Also, under the present tax laws, converting a traditional IRA to a Roth can lower the size of your taxable estate. Also, if you name your spouse as the beneficiary of your Roth IRA, your spouse can treat the inherited IRA as his or her own after you die and forego withdrawals. This allows those Roth IRA assets to keep compounding untaxed across the rest of your spouse’s lifetime. Your spouse could then name a son or daughter as a beneficiary. This would allow your children the choice to make minimum withdrawals according to his or her life expectancy. All the while these assets continue growing completely tax-free.
Keep in mind that you will owe federal and state taxes on any converted amount less any after-tax contributions you made to the traditional IRA. If you decide to convert, you will need to fill-out conversion paperwork, which you can get from the custodian—mutual fund, banker, stockbroker, etc.—of your traditional IRA account(s). The conversion paperwork isn't that complicated. If you have made nondeductible contributions to your IRA, you will need to know how much you contributed in nondeductible contributions, which you can find in your income tax forms on Form 8606, Nondeductible IRAs. You'll need to let the custodian know certain information, including:
- How you want your converted assets invested
- Whether you will pay the taxes due yourself or want the custodian to withhold the amount from the IRA's assets to pay them (remember the 10% penalty in you are under age 59 ½)
- Who you want to name as a beneficiary to receive the money upon your death
There isn’t much time remaining, and it may be difficult to get in touch with your tax or investment advisor to get the information you need to make this important decision. However, the potential benefits are material, especially for those with many years remaining before they plan to withdraw funds from their IRAs. Consider your options and seek expert advice, but a Roth conversion is certainly worth a look.