This is a guest post from Steve Juetten, a fee-only certified financial planner in Bellevue, Washington, and long-time Get Rich Slowly reader. He has written a book for consumers on the topic of 2010 Roth IRA conversions. You can find out more about Steve, the book, and his services at finpath.com.

Traditional and on-line media have been filled with 2010 Roth IRA conversion stories since the start of the new year, and if you’re wondering how this might help you and you’re confused, you’re not alone. It’s a complicated subject because to really know if a Roth IRA conversion is a good idea for you, you need to:

  1. Understand some confusing tax ideas, and
  2. Be able to foresee your future with a high degree of confidence.

It’s the second point — predicting your future — that makes knowing if a Roth IRA conversion is right for you so frustrating. Let me see if I can present the tax issues clearly so you can decide if you’re a good candidate for a conversion; we’ll leave the prediction section to the end.

Why bother?
On 01 January 2010, the law changed to allow anyone to convert their taxable IRA into a tax-free Roth IRA regardless of their income. Previously, if your joint income was more than $100,000, you couldn’t do a conversion. So why would someone want to convert a traditional IRA to a Roth IRA? There are four main reasons. If your situation fits into one of these, you’re a good candidate to consider a move like this.

  • Economics: You want to pay taxes on the value of your IRA right now when it’s smaller than it will be in the future when you take it out.
  • Thinking of your heirs: You may want to leave a tax-free asset to your heirs by paying the tax now.
  • Retirement income control: Money in a Roth IRA does not have to be withdrawn during your lifetime to meet the IRS required minimum distribution (RMD) rules.
  • Tax diversification: You might like the idea of having some of your assets in a tax-free account and some in taxable accounts because future tax policy is always un-certain. You like the idea of “hedging” your tax liability.

These are the four main reasons most people list as their motivation for considering a Roth IRA conversion. There are many other reasons you might want to convert to a tax-free Roth IRA this year, such as currently living in a state with low income tax rates, but planning to retire to a high income tax state (i.e. California); having hefty charitable contributions you’re carrying forward or want to take now; or some other unique tax situation. If you think you have a special tax situation that might be helped by a Roth IRA conversion this year, please see your tax advisor.

The tax game
The first thing to understand about a Roth IRA conversion is that you’ll owe taxes on any money you convert. These taxes should probably be paid using money from outside the IRA. Unless you’re older than age 59-1/2, any money withheld from your IRA account to pay taxes is considered an early withdrawal by the IRS and the dreaded 10% penalty applies. Same rule applies to holding the money in the Roth IRA account for at least five years. This means that not only will you have to pay income taxes on the amount you withdraw or use before five years, but you’ll have to pay a 10% penalty on that amount. Not a good idea.

If you add to your income as a result of a conversion, it may have serious side effects:

  • First, the additional income may push you into a higher tax bracket.
  • Second, the conversion may disqualify you from certain tax benefits, such as the child tax credit and the higher education tax credit.

To determine if you might be affected this way, add the value of your IRA (or a portion of it; you don’t have to convert it all) to your other income and see if it moves you to a higher tax bracket.

You can choose to delay paying the income tax due on a 2010 Roth IRA conversion and split the income into two years. You would pay the conversion tax when you file your 2011 and 2012 taxes. Keep in mind that tax rates are scheduled to increase for the 2011 tax year.

Finally, if your IRA was created with only tax-deductible contributions (for example, from a 401(k) rollover), the tax liability is straightforward. Any money you convert is taxable. But if your IRA has both taxable and non-taxable contributions, a portion of anything that is converted is taxable, and another portion is tax-free; however, you don’t get to choose which part to convert. The full value of all of your IRA accounts has to be counted for this purpose. This complexity is called the IRS pro rata rule, and you’ll need to talk to a good tax person to understand what it means to you.

Predicting the future
Now we get down to the really frustrating part of the Roth IRA conversion question: predicting your financial future. Here’s the bottom line from an economic standpoint:

A Roth IRA conversion only makes economic sense if you’re going to be in the same or a higher tax bracket when you take the money out of it.

You may be saying, “Wait a minute. When I retire, shouldn’t I be in a lower tax bracket? After all, I’m not planning on working so darn much, and instead, living off what I’ve set aside.”

And you may be right. If the tax structure stays the way it is now, you probably will be in a lower tax bracket when you retire. But that’s a big “if”, which is what makes many tax and financial planning professionals nervous. The U.S. tax system is always changing, so it’s hard to know what your tax bracket will be in 10, 20 or 30 years. Even if your tax bracket is the same now as it will be during your retirement, it’s a very close call to decide if it makes better sense to convert a taxable IRA to a tax-free Roth IRA in 2010.

Summary
You’ll need to look at your own situation to know whether it makes sense to convert. Think about the reasons you might want to convert to a Roth IRA. Consider the tax implications, and make a reasonable guess about your future tax rates. If you need help, consult with a qualified tax advisor.

If your research clearly shows converting to a Roth IRA is a good choice for you, go for it. The benefits may outweigh the risks.

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