Why Now's the Time to Convert to a Roth IRA

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IRA individual retirement accountCongress is still months away from deciding whether taxes will go up next year, and if so, by how much. But one tax-saving strategy for 2010 already seems like a great deal: converting your traditional IRA savings plan to a Roth IRA.

Why would you want to convert to a Roth? First, a little background on the two types of IRAs. A traditional IRA lets you make tax-free contributions to a savings account, but then you must pay regular income tax when you withdraw the money and any interest it has earned. With a Roth IRA, in contrast, you contribute after-tax dollars. But all of your withdrawals from a Roth are tax-free.

Because all of the earnings in the account accumulate tax-free, a Roth is a better deal than a traditional IRA. In addition, a traditional IRA requires you to take minimum distributions from the account when you turn 70.5 years old, but you never have to take any money out of a Roth, meaning you can leave it tax-free to heirs.

Unique Options Available Only Now


Why is 2010 so great for Roth conversions? Two counts, really. For one thing, Congress finally removed the upper-income limit on doing conversions. Until now, if you had adjusted gross income of more than $100,000, you didn't qualify. But starting this year, you can make the conversion no matter what your income level.

The other great advantage is that if you make the conversion before year-end, Congress has given you some unique options. You can take the money from the traditional IRA conversion as income in 2010 and pay the tax owed, which some tax advisers are counseling because taxes are likely to go up next year.

But you also have the option of taking the income and dividing it between 2011 and 2012, so you'll have to pay tax on only half the total amount each year. So if you converted a $100,000 traditional IRA in 2010, you could take it as $50,000 in income in 2011 and $50,000 in 2012.

Does Age Matter?

How to decide whether it's advantageous to make the conversion? Casey Mervine, a financial consultant at Charles Schwab in Torrance, Calif., says there are lots of factors to consider. But it really comes down to how long you have to earn back the money you must pay in taxes up-front.

"With the compounding you have over 20 years, it gets much more advantageous when you calculate the numbers for a person who is younger than for someone who is older," Mervine says. So, a 40-year-old is likely to earn much more than a 60-year-old, offsetting the tax.

But James Lange, a certified public accountant in Pittsburgh and the author of The Roth Revolution: Pay Taxes Once and Never Again, says converting can also be advantageous for people older than 60. "It is a huge misconception that older IRA owners shouldn't make the conversion," Lange says. "I often recommend Roth IRA conversions to retirees and seniors."

Lange says the key question is not how much you have in total dollars, but how much you have in purchasing power.

Mathematical Proof

He gives the following example: An investor has $100,000 in a traditional IRA and $25,000 in the bank. If he takes the money out of the IRA and uses the $25,000 to pay the taxes due, he is left with $100,000 to spend. But if he converts the traditional IRA to a Roth IRA using the same funds, he will be left with $100,000 in an account that generates income tax-free forever.

"It doesn't matter if the person is 40-years-old or 60 or even 80, I can prove mathematically that given reasonable assumptions over time, the person who makes the conversion to a Roth IRA is going to have more purchasing power than someone who doesn't," Lange says.

Still, Lange says, conversions aren't for everyone, especially people whose incomes are likely to go down in the years ahead or for someone who needs to spend the money in the near future.

Convert Your 401(k), Too

Mervine points out that a conversion makes sense only for investors who have sufficient money outside the IRA account to pay the taxes due. For example, if a 40-year-old converts a $50,000 in a traditional IRA to a Roth and uses IRA funds to pay the taxes due, he'll have to pay taxes not only on the $50,000 withdrawal but also on the $15,000 withdrawn to pay the taxes. In addition, there's a 10% penalty for early withdrawal on the money used to pay the tax.
Accountants have figured out that using IRA money to pay the taxes results in what amounts to a break-even transaction, so it doesn't make sense to convert unless you can pay the tax with after-tax dollars held outside the IRA.

Another interesting development in 2010 is that Congress last month for the first time allowed for converting traditional 401(k) savings accounts held at employers to Roth 401(k)s. The same logic applies to these accounts: Given the widespread expectation that taxes will increase next year, making the conversion this year could save substantial money.

For example, if you're in the top tax bracket of 35% and you convert a $1 million 401(k) this year, you'll pay $350,000 in taxes. But if you wait until 2011 and the top tax rate goes up to 39.6% -- as is currently scheduled when the Bush tax cuts expire -- then you 'd pay $396,000, or $46,000 more.

Just another reason to consider converting to a Roth retirement fund this year. Psst, it's nearly November.

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39 Comments

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curryflawlibs

its tme to buy more gold before the 401K paper IOU goes completely under, yuoll be begging gold to drop to $3000 oz.

October 25 2010 at 8:25 PM Report abuse rate up rate down Reply
randy

The government just wants every one to invest in Roth now so as to get tax dollars now then in 30 or so years they will change the laws where they will be able to get tax off of the Roth also nothing is written in stone they can change the laws any time

October 25 2010 at 6:36 PM Report abuse +1 rate up rate down Reply
ronsjigslures123

THE BIGGEST bitch the usa people have out of all the bitching is when there states, countys, goverment raise TAXES. You want to get people rialed up FAST raise taxes.

October 25 2010 at 5:01 PM Report abuse rate up rate down Reply
ronsjigslures123

If this country keeps taxing everything in sight and don,t think they will not because your a fool, and the states also. This country will be the worst taxed country in the world. No one will want to do bussiness with this country after a while, because it will not be worth it, high taxes kills countrys for large influx of money flowing in and out of a country, and even states. Most states with high taxes people run from those places, and bussiness don,t set up shop there either. This country better be careful because no one will waht ant part of this country and you think this recession is bad, High Taxation all threw history has KILLED WHOLE countrys, its all in the history books. The washington brain people better start to read about the past high tax countys and how they fell totaly apart.

October 25 2010 at 4:57 PM Report abuse +1 rate up rate down Reply
ggrehawick

I'm surprised the Democrats have not already mandated that all IRA's and 403B's must be converted to Roth's this year and all the taxes be paid this year. Talk about a windfall for the Democrats to redistribute as they wish.

October 25 2010 at 4:44 PM Report abuse +1 rate up rate down Reply
ronsjigslures123

Every thing and any money the people will make off any investment will be taxed in the near future. You have to look at the whole picture here. The goverment is broke and they have a huge payrole, selling arms jets and croppers only go so far in money into the usa. Our exports are really low and the USA can,t raise IMPORT tax on china or any other country because they will raise there prices or tell us to take a hike. The states and gas taxes can,t go any higher and the taxes on electric bills and heating is at a all time high. SO WHERE DO you think they will have to find the money to run this place. The next generation will have tax on everything they buy , take a crap, or eat to keep this country going. and buy the way you are TAXED when you take a crap, the water bill is taxed...whats next no its impossible the air we breath? The goverment is in the people bussiness and that means taxes on everything. So to find places to put your money without tax,s is and will be impossible. EXCEPT FOR ONE PLACE

October 25 2010 at 4:28 PM Report abuse +1 rate up rate down Reply
jim

It took years for working people democrats and republicans, indepentents to save for retirement, and now Obama and his followers think those who worked hard and saved should pay for all the bailouts? Its highway robbery!,and a national crime. The people who want it now are just as quilty of robbery,they think they are entitled to other peoples money.Benevelence is not an entitlement.Good people help others by choice , not by requirement.Think before you vote.

October 25 2010 at 2:14 PM Report abuse +3 rate up rate down Reply
djohn37

Roth IRAs must be in force for five years or the waiver of taxes on the interest earned is voided and the interest amount is taxable.

October 25 2010 at 1:28 PM Report abuse rate up rate down Reply
Kiss

Obama plans to 'merge' your IRA's, 401's and any privately held interest earning accounts into the 'social security system'. Maybe we should all demand to be paid in cash and change our with-holding status to 99 dependents. At least, we will have our cash in our pockets and our government will have nothing to work on. Holding them hostage until they listen to us is the only civil option. Voting in more of the same will not work. And the thought of my grandchildren paying for someone elses' greed is not a pleasant one.

October 25 2010 at 12:49 PM Report abuse -2 rate up rate down Reply
ggrehawick

I am 69 and pay taxes on a portion of my social security. The amount of tax I pay on social security is dependent on my total income. If I covert $50,000 to a Roth I must clain that as income and my taxes on the social security portion of my income will rise in addition to the taxes on the coversion. I'm staying put unless someone can point out the flaw in my thinking. If I get to the state that my entire social security is taxes then conversion makes more sense since my tax from social security will already be at its maximum.

October 25 2010 at 11:40 AM Report abuse +2 rate up rate down Reply