Starting January 1, 2010, new rules went into effect that abolished income limits for conversions from a traditional IRA to a Roth IRA, and many Americans are now asking the question: is now the time for me to convert? There are a few factors to consider when deciding whether to convert from your traditional retirement account to a Roth IRA.
Previously, only taxpayers with modified gross-adjusted income under $100,000 were allowed to convert from a traditional to Roth IRA. The new rules have opened the door for higher income individuals to convert to Roth. In a traditional IRA contributions are tax-deductible, but all withdrawals are taxed as ordinary income at the current tax rates, including taxes on all of the capital gains, interest, dividends, etc., that were earned over the past years. With a Roth IRA contributions are not deductible, but distributions are 100% tax-free when they are withdrawn. If you decide to convert from a traditional to Roth IRA, you pay tax on the converted sum.
As a rule of thumb, you should not roll over into a Roth IRA if you do not have the liquidity to fund the tax expense from sources other than the initial principal. You could also consider a partial conversion up to the level in which you could fund the tax expense from assets other than the traditional IRA. Also, the new rules make a conversion to Roth IRA less immediately painful. With conversions made this year, you have the option of reporting half the conversion income on your 2011 tax returns and the rest on your 2012 tax return, thus pushing the deadline to as late as October 2012 with an automatic extension.
The most basic issue in this discussion is whether the initial tax cost of conversion is worth it. The answer depends on your time horizon and what you need that money for. If you are purely making the decision to convert on the basis of saving more money for your own retirement (rather than building wealth for heirs), the question becomes: how many years will it take to recover that initial tax expense due to tax-free distribution from the Roth IRA? The answer to that question is somewhat subjective, as it must take into account your projected longevity. A middle aged person planning for retirement would be more inclined to convert than someone approaching retirement age if both were making the switch for the sake of their own net retirement income, but an older person might be motivated my other factors. A motivation for both parties to convert would be a higher projected tax rate by 2013 (the deadline for reporting all conversion income).
Say, for example, you decided to convert to a Roth IRA and died a day later, your large outlay in the form tax expense would not be wasted. In that case, your beneficiaries would not only enjoy the benefits of tax-free distributions from the Roth IRA, but also realize a concurrent reduction in estate tax expense. Another great advantage to a Roth IRA is that when you hit the age of 70 ½ you are not required to begin taking distributions, which is the case with a traditional IRA. This can allow time to build more wealth if you so choose, both for yourself and your heirs.
So, after all of that, should you fully or partially convert from a traditional to a Roth IRA? The answer ultimately lies in whether you believe tax rates will be higher in the future, and most do. Just make sure that if you do choose to convert, only do so in the amount which you can afford to foot the tax bill with assets not including the current account principal.
