2010 marks the first year many of us will be able to convert our existing IRAs (or workplace savings plans) to a Roth IRA. Income limits that had prevented individuals or couples with Adjusted Gross Incomes of more than $100,000 from completing a conversion, no longer exist. The opportunity is now open to everyone to potentially benefit from tax-free growth of earnings. If you haven't taken a closer look at a Roth conversion, now might be the time to do it. This could allow you a lot more flexibility in managing cash flow needs in a more tax-efficient way when you reach retirement.
WHAT'S THE APPEAL OF THIS? Perhaps the most attractive feature of a Roth IRA is that earnings grow on a tax-deferred basis and distributions are tax-free. This could be particularly advantageous if you anticipate that your tax bracket will be higher than it currently is, by the time you begin withdrawing from the account. Contributions will be taxed at your current tax rate when you make the conversion, but you will be able to recuperate all of the investment growth you accumulate in the account, tax-free, once holding period requirements are met. (If requirements are not met, taxes and penalties may apply.
THE COMING DEADLINE: Under current law, the ability for anyone to convert regardless of income level is a "permanent" change in the tax law. But the deadline of December 31, 2010 is fast approaching for those making a conversion who want to capture a significant, one-time tax advantage. A conversion completed in this calendar year qualifies for a special deferral of payment of the tax due as a result of the conversion.
You can choose to claim the income from the conversion on your 2010 tax return. Also, you can claim half the income generated by the conversion on your 2011 tax return (in 2012), and the other half on your 2012 tax return (to be filed in 2013). This not only allows you to delay tax payments, but by spreading out the impact on your total income, may create the potential to retain a lower tax bracket in both those years, reducing your overall tax liability.
FUTURE TAX RISKS: Some are worried that the government's desire to find new tax revenue sources to offset current and future demands on programs will results in tax policy changes. Could this mean Congress will require that Roth IRA distributions would lose their tax-free status? No one can predict with certainty what will happen. It's just as possible that Congress could decide to alter the rate of taxation levied on distributions from traditional IRAs or workplace savings plans (such as 401(k)s. Making decisions today about your financial future cannot be based on sheer speculation. You have to use the best available information which exists today. That means your interests will best be served by working with the tax laws as they are currently defined rather than trying to predict the future actions of Congress.
PAYING FOR THE CONVERSION:
A key hurdle to making the decision to convert is the tax issue. You must come up with money to cover the taxl iabiity. The conversion is most likely to work to your long-term benefit if the tax bill can be paid using dollars available in your existing taxable accounts. This allows you to maximize the tax advantage of your Roth IRA by keeping your retirement savings invested.
One more reason to convert before the end of the year.. if you changed your mind before October 15th (last week as we're talking about this) you can "recharacterize" your Roth IRA, returning the money to a traditional IRA and avoiding the tax consequence of conversion. This opportunity for a "do over" right now reduces the risks involved with giving a Roth conversion a try this year.