RSM Resources

Since its inception in 1998, the Roth individual retirement account(IRA) has been a favorite of many investors. A Roth enables investors to pay taxes on contributions today in exchange for tax-free growth and tax-free distributions at retirement. Traditional IRAs, by comparison, offer investors the opportunity to make tax-deductible contributions and enjoy tax-deferred growth — but pay income taxes when they receive withdrawals from their IRA.

Why doesn’t everyone contribute — or convert to — a Roth IRA? Until recently, only investors with modified adjusted gross income (MAGI) below $166,000 and individuals with MAGI below $114,000 were eligible.

Now everyone, regardless of income or filing status, can convert their traditional IRAs to Roth IRAs in 2010, thanks to the Tax Increase Prevention and Reconciliation Act (TIPRA). The measure lifts a restriction that prevents investors with modified adjusted gross incomes above $100,000 from converting traditional IRAs to Roth IRAs. However, conversion of a traditional IRA to a Roth IRA is not without tax consequences.

Just because you can convert your traditional IRA to a Roth IRA doesn’t mean you should, says Arne Morris, a wealth management advisor at RSM McGladrey. The question of whether to convert or not in 2010 doesn’t have a"one-size-fits-all" answer, Morris says.

Investors must contemplate conversion based on their unique circumstances, which could favor traditional or Roth IRAs. Factors such as current and future tax brackets and income levels should be part of the equation. Other considerations should include how the investor will pay income taxes due at conversion and how long the Roth IRA will remain untouched. Investors also need to evaluate the size of the IRA when they couple it with their investment returns and estate plans — and in relation to their health profile and life expectancy.

Luckily, investors have the next three years to crunch the numbers and seek help from tax advisors or financial planners to analyze whether conversion is the right course of action.

A primer on IRAs
In short, a traditional IRA gives you a tax break today; a Roth IRA gives you one in the future.

Ina traditional IRA, investors make contributions with pretax or after-tax dollars, subject to certain limitations. Pretax contributions reduce your taxable income — and therefore the taxes you owe — in the same year. But when you withdraw the funds at retirement, you pay taxes on both your pretax contributions and your investment gains. In addition, once you reach age 70-1/2, you’re required to take yearly minimum distributions and can no longer contribute to the account.

Ina Roth IRA, you make contributions of after-tax dollars, but in retirement, you can withdraw the principal and earnings free of income taxes, assuming you’re 59-1/2 and the account has existed for five years. Unlike traditional IRAs, required minimum distributions don’t apply to Roth IRAs. So you won’t have to take distributions from your account when you turn 70-1/2. Additionally, as long as you have earned income, you can continue to make contributions throughout your lifetime.

Reasons to convert

Given the complicated tax questions, how will you know whether converting your retirement savings to a Roth IRA is right for you?

First, it may make sense to convert if you suspect your tax bracket will be the same or higher when you are ready to withdraw funds. Even if your income level remains the same, Congress may decide to raise the marginal income tax rates in that time frame, which means your tax burden could become greater over time.

Second, the longer you plan to leave your assets invested, the more time your funds will have to grow — and the more attractive the conversion may become.

Third, if you don’t think you’ll need your IRA funds, and you want to do your heirs a favor, convert to a Roth IRA as an effective estate planning strategy. Pay the income taxes in 2010, and your heirs won’t have to pay taxes on those funds when they receive their inheritance.

Paying the piper
During an IRA conversion, you withdraw funds from your traditional IRA and roll them over into a Roth IRA. You must report the funds as income. The tax implications from the conversion will vary based on whether you took a tax deduction on the contributions. If you deducted your IRA contributions, you’ll have to pay taxes on both the principal and the earnings. If you didn’t, you’ll pay taxes on just the earnings. Depending on what this amount — and whether it exceeds the amount allowed at the top of your current income tax bracket, causes you to pay at a higher tax rate — it could be a significant tax bill.

That’s why many financial planners believe that conversion makes sense only if you have money outside your retirement plan to pay the tax bill. If you must use your IRA to pay for the taxes, you face several risks. First, if you’re under age 59-1/2, you’ll have to pay a 10 percent penalty on the portion of the IRA you use to pay the conversion tax. Second, depending on your age,you may not have time to recoup the loss. After all, the ideal situation is to end up with the same number of dollars in a Roth IRA (tax-free) as you had in your traditional IRA (taxable).

For those interested in the Roth conversion, experts recommend setting aside some liquid assets now to pay for the conversion tax.

Of course, as an added incentive to convert your IRAs to Roths in 2010, TIPRA will allow you to defer the tax bill, paying half in 2011 and the other half in 2012. However, it’s important to know that 2010 will be the last year for the low income tax rates. Current law provides for an increase in tax rates in 2011. Therefore, if you were to choose to spread your tax payments over the two-year period in 2011 and 2012, you might be hit with higher tax rates.

Keep in mind that tax laws will continue to evolve between now and 2010. A new law repealing the conversion provision — even before it takes effect in 2010 — is possible. Why? Because, while it is estimated that Roth conversions could yield $6.4 billion in revenue between 2010 and 2015, critics argue that it will cost the U.S. Treasury billions of dollars in lost tax revenue in years following 2015. This is the period when withdrawals from unconverted IRAs would have been taxed.

To ensure you make the best decision based on your individualcircumstances, it’s important to monitor any changes in legislation and continue to consult with a financial planner or tax professional.