Beginning in 2010, the $100,000 modified adjusted gross income limit for conversion of IRAs to Roth IRAs has been waived. This presents an opportunity for thousands of investors whose income made them ineligible for Roth conversions in the past. In addition, the taxable income resulting from a Roth conversion (in 2010 only) can be spread out over two tax years. Half of the income can be recognized in tax year 2011, due by April 15th, 2012, (October 15th with extensions) and the other half recognized in 2012, due April 15th, 2013, (October 15th with extensions.) Alternatively, the income can be recognized in 2010, the year of conversion.
Why consider converting? Well, the advantages of a Roth IRA can be compelling. The Roth is funded with after tax dollars, and all future growth and income, subject to a five year holding period, can be withdrawn completely tax free. Roth IRAs are not subject to required minimum distributions at age 70 ½, and a spousal beneficiary can take over a Roth IRA, make it their own, and allow it to continue to compound. Distributions are required only after a non-spousal beneficiary inherits the account. A Roth IRA can provide a multigenerational shelter from taxes, no matter how high tax rates might rise in the future.
Still, Roth conversions don’t make sense for everyone. It’s important to review your overall situation with your tax preparer so you can see the full implication of a conversion. For instance, additional income resulting from a Roth conversion may increase the taxable portion of your Social Security, and may lower or eliminate your ability to make use of certain income related itemized deductions in 2011 and beyond..
Here are some guidelines. Consider your present and future tax rate. If you think your tax rate will fall significantly, you may be better off leaving your IRA alone and paying taxes on the money as you withdraw it. If your future tax rate (or that of the ultimate beneficiary) will be higher, then conversion may make more sense. If you are 70 ½ or older, you will have to withdraw your required minimum distribution before you convert any of your IRA funds to a Roth. You cannot convert your required minimum distribution.
How will you pay the additional conversion related tax? A conversion probably won’t make sense unless you have money outside your IRAs to pay the tax bill. If you withdraw from the IRA to pay the tax you’ll be taxed on the withdrawals, and may also be subject to a 10% penalty if you're under 591/2.
Time is a critical factor. Will you need to use the money in your IRA during your lifetime? In general, the longer you have until you (or your children or grandchildren) plan to withdraw your earnings tax-free from the Roth, the better the numbers will look. As with any decision that has both tax and investment consequences, be sure to consult with your tax professional and investment advisor, to be sure a Roth conversion is appropriate and completed correctly.