There's been a lot of conversation and buzz about the new rules for converting Traditional IRA accounts to Roth IRA's in the year 2010. Basically, there will be no income limits and everyone is eligible to convert their Traditional IRA to a Roth IRA.
What does this mean and is it something you should consider?
There are 2 types of IRAs – traditional and Roth. The tax deductible traditional IRA (including IRA rollovers & SEP IRAs) is funded with pre-tax income and lowers your income for tax purposes. The money grows tax free until you withdraw it and at that time you pay ordinary income tax rates on the entire amount withdrawn. There is an additional 10% penalty if you withdraw funds before age 59 ½. The IRS requires you to take minimum distributions at age 70.5.
A Roth IRA is funded with after tax income but you can only contribute if your Adjusted Gross Income is under $105,000 if you are single and $166,000if you file jointly. You can withdraw money tax free as long as you have the Roth for 5 years and you are older than 59 ½. You are not required to take mandatory distributions.
Currently, you are not allowed to convert from a Traditional IRA to a Roth IRA if your income is over $100,000 but in 2010 (and only 2010) there will be no income limits.
If you convert, you will owe taxes on the entire conversion amount. The new rule allows you to paythe entire tax due in 2010 or you can elect to pay ½ of it in 2011 and ½ of itin 2012.
Should you convert? There is not a one size fits all answer. Every situation is unique. While the calculation is fairly easy, there are many assumptions that the decision should be based on:
What is your tax rate now vs. what will it be a tretirement?
What will your tax rates be in 2011 and 2012 when the tax is due?
Will tax rates rise? We don't know, but they may.
Can Congress change the rules on tax-free withdrawals of the Roth in the future? It is always possible.
Will your income drop or be the same or more in retirement?
The funds to pay the tax need to come from funds outside the IRA. Would those funds be better invested elsewhere? Be cautious on the assumptions you use for inflation, future income tax rates and the rate of return of the IRA.
Everyone's situation and goals are different, so before you decide, consult your Certified Financial Planner or your CPA.