In 2010, any taxpayer regardless of income will be eligible to convert an existing IRA to a Roth IRA. As the law stands right now, you can’t convert from a traditional IRA to a Roth IRA if your modified adjusted gross income (MAGI) on your federal income tax return is over $100,000. Beginning in 2010 (and beyond) that limitation is abolished (unless there are changes to the tax code in the future). In addition, there's a special rule in place for 2010 only that will allow you to recognize 100% of the conversion income in 2010 or split it equally between the next two tax years.
Even though you will have to pay current income tax on the amount you convert to a Roth IRA, it still might make sense if:
1) You think you will be in the same or a higher tax bracket at retirement.
2) You have a long enough time horizon.
3) You can pay the tax from sources other than your IRA.
4) You don’t need the money and want to leave tax-free funds to your heirs.
A few important notes about paying the conversion tax:
If you pay the tax from your IRA, you would lose the potential benefit of tax-free growth on that amount, defeating the purpose. Of course, if you’re under 59½, withdrawing money from your IRA to pay the tax would be an even worse idea, since you would also incur a 10% federal penalty. (State penalties may also apply.)
Ideally, you will have cash on hand to pay the income tax. If you need to sell appreciated assets to pay the conversion tax, the additional capital gains tax would work against the case for a Roth conversion. Assuming you have the cash available elsewhere to pay the conversion tax, you still need to account for the “opportunity cost” of what that money could have earned had it remained invested in a taxable account.
Income taxes aside, individuals may find that converting part or all of a traditional IRA to a Roth is advantageous for estate-planning purposes, especially if there is a significant IRA balance that doesn’t need to be tapped during the owner’s lifetime. Though the value of a Roth will still be included in the gross estate, because there are no required minimum distributions, the account could grow larger than it otherwise might under traditional IRA distribution rules; leaving more for heirs to withdraw income-tax-free over their lifetimes. What's more, the income tax paid at the time of conversion (preferably from assets other than the IRA) will reduce the owner’s gross estate. In effect, the account owner is prepaying income tax on behalf of future beneficiaries without it really counting as a taxable gift.
We will be discussing Roth Conversions with clients in the coming months to determine if a conversion would be advantageous as we do expect future tax rates to be higher than they are today. In the meantime, if you have any questions please let us know.
