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Article: Roth IRA Conversions Still Alive

Apr 26, 2011

They’re Not for Everyone, but They Can Be an Attractive Alternative

by Doug Wheat, CFP , published in January 2011 issue of Healthcare News

If you missed the opportunity to convert your traditional IRA to a Roth IRA in2010, there is good news: Roth IRA conversions are still alive in 2011.Roth IRAs are attractive retirement accounts because they hold the promise of tax-free investment gains, no required minimum distributions (except for inherited Roth IRAs), potentially lower estate taxes,and lower income taxes on inherited IRAs, among other benefits. But Roth IRAs are not for everyone, and it important to pay careful attention to how the details of the rules apply to your particular situation.

When you do convert an IRA to a Roth IRA, you have to pay income taxes on the amount you convert. In effect, you are volunteering to pay taxes now in order to receive tax-free growth in the future. A few employers also allow a conversion from a 401(k) to a Roth 401(k),but this new provision is uncommon.

Direct contributions to a Roth IRA may be withdrawn tax-free at any time. Rollover and converted (before age 59 1/2) contributions held in a Roth IRA may be withdrawn tax- and penalty-free after the ‘seasoning’ period (currently five years). Earnings may be withdrawn tax- and penalty-free after the seasoning period if the condition of age 59 1/2 (or other qualifying condition) is also met. Another plus is that, with a Roth IRA, there is no rules requiring distributions that must begin for holders of traditional IRAs after age 70 1/2. So if you don’t need the money, investment gains in your account can continue to compound indefinitely without being eroded by taxes.

Before 2010, you couldn’t convert a traditionalIRA into a Roth in a year in whichyour modified adjusted gross incomeexceeded $100,000. That restriction waseliminated starting in 2010 and resulted inan explosion of interest in Roth IRA conversions. The ability to do Roth IRA conversionsfor all income levels will continuein 2011 and beyond. The attractiveness of aconversion has not diminished because therecently signed Middle Class Tax Relief Actof 2010 keeps tax rates from rising foreveryone in 2011 and 2012.

So if you missed the opportunity to convertto a Roth IRA last year, now you haveanother chanceto review your personal circumstances todetermine if a conversion is right for you.Here are a few important questions to consider:

  1. How will you pay the tax on the conversion?If the money to pay the tax has tocome out of the tax-deferred assets you’retransferring (your IRA or 401(k), it willlimit the benefit of the conversion.Remember, you need to pay both the federaland state income taxes on the conversionamount.
  2. What’s your tax rate? How much youpay now and your expected income-taxrates during retirement directly affect theconversion equation. While you might normallyexpect to be in a lower bracket duringretirement, federal, state, and local tax ratesmay increase in the future.
  3. Did you make non-deductible contributionsto your traditional IRA? You won’tbe taxed to convert the non-deductiblecontributions, but the earnings will be subjectto tax on conversion.
  4. How old are you and other membersof your family? Your age affects how longassets will be able to grow tax-free in a convertedRoth IRA — and the longer theygrow, the bigger the tax advantage.
  5. Do you need the money? If you haveyoung children who are likely to inherityour Roth IRA, they may be able to spreadout distributions (required after theaccount goes to the next generation) overmany decades. If so, the compoundingeffect of the tax-free status can be enormous.

With all of these factors to consider,deciding whether to convert can be complicated.If you do have adequate savings topay the tax on a conversion, you mightwant to consider whether your income-taxrate will be going up in the future. With allthe uncertainty in tax rates, this is obviouslydifficult to foresee, but let’s look at a coupleof situations in which physicians andother highly compensated individuals may find themselves.

A medical resident may be earning a smallfraction of the salary he or she anticipatesreceiving in just a few short years. Thus, heor she is likely to be in a lower tax brackettoday than in the future. If he or she hasbeen able to save some money in a retirementplan and in outside savings accounts,despite having large school loans, a conversionmay be financially attractive.

A physician in the middle or later part ofher career may find herself at one of the toptax brackets. If she will need all or most ofher retirement savings for her own retirementneeds, a Roth conversion may not bean advantage. However, if she has contributedafter-tax money to an IRA over theyears, or has done the same for a spouse,these accounts can be attractive Roth IRAconversions because the tax will be dueonly on the earnings, not the contributions.However, the rules for determining taxbasis can be tricky, so you need to be carefulbefore you proceed.

A physician with large accumulated savingswho retires at age 65 may find himselfin a window of opportunity with low taxes,which may provide an attractive opportunityfor a partial Roth conversion. This is particularlytrue if the person does not plan totake Social Security benefits or IRA distributionsuntil they turn 70. In this scenario,it is entirely possible for the person to betemporarily in one of the lowest tax bracketseven though they have a significantamount of assets. It may be a golden opportunityfor a Roth conversion. As an addedbonus, Roth conversions decrease futureminimum required distributions from traditionalIRAs.

While, for many people, establishing aRoth IRA is a great way to genenerate taxfreeretirement income, moving assets froma traditional IRA to a Roth doesn’t makesense in every case. And even if the positivesout weigh the negatives, it may be bestto convert only a portion of your IRA assetsin any one given year. It’s also important toknow that it is possible to undo Roth IRAconversions within a limited window oftime.

With the continued low tax rates for 2011,many people may still find it an attractive yearto do Roth conversions.

This material is generic in nature. Before relying on the material in any important matter, users should note date of publication and carefully evaluate its accuracy, currency, completeness, and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances.

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