Effective January 2, 2010, Roth IRA conversions are no longer limited by an earnings test. With this earning test eliminated many financial professionals are advising individuals to convert their traditional IRAs into Roth IRAs. But is a Roth IRA conversion right for everyone? In this article we will explore the pros and cons of doing a Roth IRA conversion.
Overview
Traditional IRAs allow individual who qualify, to make a tax deductible contribution. When it comes time to make qualified distributions, these distributions are taxed at whatever your effective tax rate might be in the year of the distribution. Roth IRAs allow individuals who qualify to make contributions which are not tax deductible. When qualified distributions are made from a Roth IRA, such distributions are tax-free.Often, individuals who change jobs or are terminated have the option of rolling their retirement plan funds into an IRA. In the past, most individuals have rolled these retirement funds into traditional IRAs (rollover IRAs). Effective January 2, 2010, individuals with traditional IRAs (rollover or otherwise) are eligible to convert their traditional IRAs into Roth IRAs, irrespective of their level of income.
Pros of a Roth Conversion:
1. Tax-Free Distributions – Qualified Roth IRA distributions are never subject to federal income tax. Roth IRAs represent a hedge against future tax increases;
2. No Required Minimum Distribution – Traditional IRAs have a requirement that distributions must begin in the year an individual turns 70 1/2 (or by 4/1 of the year following the year an individual turns 70 1/2). This is called a Required Minimum Distribution. Roth’s have no Required Minimum Distribution requirement. Thus, there is no requirement to withdraw any Roth funds during one’s lifetime;
3. Reduction in Taxation of Social Security Benefits – Because qualified Roth distributions are tax-free, you can reduce the amount of your Social Security benefits which are subject to income tax. Generally, the amount of Social Security benefits which are subject to income tax are tied to the amount of other types of taxable income you receive during the year. By converting traditional IRAs into a Roth, you can reduce your future taxable income and, thus the amount of Social Security benefits which are taxable;
4. Penalty-Free Withdrawals – Taxpayers can withdraw the converted amounts without penalty after five years;
5. Benefits taxpayers most who expect to be in a higher tax bracket at or near retirement age;
6. If the taxpayer’s traditional IRA has lost value recently, converting to a Roth can be done at a lower tax cost;
7. Benefits taxpayers most who have a long time horizon and will not need to withdraw from their converted Roth for some time;
8. Provides an income tax-free legacy for your heirs;
9. The tax on 2010 conversion amounts may be paid 50% in 2011 & 50% in 2012 (deferred).
Cons of a Roth Conversion:
1. For taxpayers who expect to be in a lower tax bracket at or near retirement, the tax benefit of a Roth IRA may be reduced;
2. If the taxpayer does not expect to live very long then the stretch/legacy/tax benefits of the Roth will be reduced;
3. Roth conversions come with a tax cost. Payment of the tax on conversion should be from available cash, and not from the IRA itself, as such a distribution will be subject to a 10% penalty, if the taxpayer is under 59 1/2, as well as income tax on the distribution.
Best Candidates for a Roth Conversion
Some taxpayers benefit from a Roth conversion more than others. The best candidates for a Roth conversion include:
1. Wealthy Taxpayers;
2. Taxpayers seeking to reduce estate settlement costs;
3. Taxpayers who will not need to withdraw from the converted Roth IRA for some time;
4. Young taxpayers who are high-income earners;
5. Taxpayers who believe they will be in the same or a higher tax bracket in retirement.
For more information please consult a tax advisor or attorney to determine if a Roth IRA conversion is beneficial to you.