Roth IRA Conversions

Roth Individual Retirement Accounts (IRAs) provide benefits not available from traditional IRAs. Unlike traditional IRAs, distributions from a Roth IRA are generally not taxable. The flip side is that contributions to a traditional IRA are generally deductible and are, therefore, made with pre-taxed income dollars. Contributions to a Roth IRA are always made with after-tax income dollars and there is no current income tax deduction for the contribution. Earnings in both types of accounts are not taxed at the time they are earned.

There are other advantages to a Roth IRA as well. There are no required minimum distributions (except to a post-death beneficiary). There is no age limit on setting up the Roth IRA or making contributions to it. (A traditional IRA cannot be set up or have contributions made to it after the owner reaches age 70 1/2.) Finally, because distributions from a Roth IRA are not includible in income, the taxpayer’s adjusted gross income will be lower, reducing the tax rate for other income, reducing the threshold for certain itemized deductions, and potentially reducing the portion of any Social Security benefits that are taxable.

Many taxpayers have elected to convert their traditional IRAs into Roth IRAs. In years past, however, this conversion had been allowed only to taxpayers whose modified adjusted gross income did not exceed $100,000. Beginning in 2010, there is no longer any income limitation affecting such conversions. Converting your traditional IRA to a Roth IRA is something to consider.

Conversion, however, is not tax-free. A conversion is treated as a distribution of all the assets in the traditional IRA which is taxed as ordinary income. (The only exception is that if the traditional IRA has nondeductible contributions, those are not included as income.) While the distribution from the traditional IRA is taxable as income, the penalty on early distributions (prior to attaining age 59 1/2) does not apply. If, however, not all of the money withdrawn from the traditional IRA is transferred to the new Roth IRA, the money not transferred to the new Roth IRA will be subject to the early distribution penalty (generally a 10% tax on the amount received).

For those taxpayers who can afford to pay the income tax on the converted assets without using any of the distribution, the conversion can be beneficial in the long run. Also, for conversions made in 2010 an individual may elect to defer and split the income tax on the distribution with half reported in 2011 and half in 2012. The deferred income will be taxed at the rates in effect for 2011 and 2012 (which could be higher or lower depending upon what Congress might do to the tax laws!). Alternatively, the entire amount can be taxed as 2010 income at current rates. For taxpayers in higher brackets, there is a greater risk as indications are that the top marginal tax brackets will be raised. For those in lower income tax brackets, the risk of deferring the income and gambling on the rates to be in effect in 2011 and 2012 may be more worthwhile.

Depending upon your age and future retirement needs, keeping all of your money in a traditional IRA may be more advantageous than converting to a Roth IRA. Certainly, for those who would need to use part of the traditional distribution to pay the taxes, the benefits have to be weighed very carefully. That portion of the distribution used to pay taxes instead of being rolled over to the Roth IRA forever loses its ability to grow tax free in the future and is not replaceable.

For those who choose to make the conversion and then have second thoughts, there is also the possibility of “Recharacterization.” For taxpayers who later determine that the cost of the conversion outweighs the benefits, it is possible to recharacterize the Roth IRA as a traditional IRA. This must be done by the due date, including extensions, of the time for filing one’s income tax returns (generally October 15).

For those whose traditional IRAs were adversely affected by the downturn in the market, the conversion into a Roth IRA may be less expensive than it might otherwise have been. Those who might consider converting might want to do so sooner rather than later so that subsequent market gains can accrue tax-free in the Roth IRA.

For those who are close to retiring and will soon be drawing on their traditional IRAs, the conversion is likely not to be worthwhile. Younger taxpayers may realize greater benefits as there will be a longer period of time before retirement to allow the Roth IRA to build up in value.

Finally, one must also consider future changes in the law. While current law provides that Roth IRA distributions are tax free, there is no guarantee that this will always be the case. Social Security benefits were not taxed in the past, but they now are. It could be that in the future the government will need to raise revenue and tax these benefits as well.