Since its creation more than a decade ago, the Roth IRA has been one of the best tax breaks around, but it's been closed off to higher-earning taxpayers.
That will change next year.
Starting in 2010, the rules governing the conversion of a traditional IRA into a Roth IRA will allow anyone – regardless of income – to switch their existing retirement savings account.
The change in 2010 "has the potential to be a fairly big deal," said Rande Spiegelman, vice president of financial planning at the Charles Schwab Center for Financial Research.
Depending on your financial circumstances, converting your traditional IRA to a Roth IRA might be a smart move, but consumers should do their homework first.
"Look before you leap," Spiegelman said. "Just because you can do it doesn't necessarily mean you should."
The benefits of a Roth IRA are substantial. Here's why:
• Contributions to a Roth aren't tax-deductible, but earnings can be withdrawn tax-free if you're at least 59 ½ years old and have had the Roth for at least five years.
• There's no mandatory distribution age as there is with a traditional IRA, which means if you don't need the money, you can leave it in the Roth to continue growing.
In a traditional IRA, contributions are tax-deductible and taxes are paid when earnings are withdrawn. Withdrawals can begin at age 59 ½ and are mandatory by age 70 ½ because Uncle Sam wants the income taxes due him.
Despite the benefits, the decision to convert your IRA shouldn't be automatic.
As a general rule, tax planners advise against paying a tax today that you can defer until a later date. But there are always exceptions, and converting to a Roth IRA now may well be one of them.
When you move from a traditional IRA to a Roth IRA, you pay income tax on the amount converted.
But for 2010 only, you can spread the income over two years.
So if you converted a $100,000 traditional IRA in 2010, you could report $50,000 in ordinary income in 2011 and $50,000 in 2012.
"The tax hit is real and it's permanent," Spiegelman said.
If you're considering converting your IRA, here's a checklist to go through before deciding:
Your tax bracket
Try to determine what tax bracket you'll be in when you retire, and whether it will be higher or lower than your current bracket.
"The people that Roth conversions are the best deal for are those who can pay the conversion taxes out of non-IRA assets, have at least 10 years to let the money grow before using it and will be in the same or higher tax bracket in retirement," said Jean Keener, a financial planner at Keener Financial Planning in Keller.
On the other hand, "if you think you'll be in a lower income tax bracket, the taxes you pay today could end up being higher than the taxes you'd pay when you're ready to make withdrawals," Spiegelman said.
So in that situation, it might not benefit you to convert your IRA. "It wouldn't make sense to pay at a higher rate today if you can wait and pay less tax," Spiegelman said.
What's more, the taxes you pay now would reduce the amount of money available to you to grow.
If the amount you convert would bump you into a higher tax bracket, consider converting only the amount that allows you to stay within the same tax bracket.
Paying the tax
Make sure you know where you'll get the funds to pay the conversion tax.
"If you take money out of the IRA to pay the conversion taxes, it can be costly," said Ken Kilday, a certified financial planner and wealth manager at USAA. "You compound it in the wrong direction."
Plus, if you're under 59 ½ and tap your IRA, you'll also be hit with a 10 percent penalty.
"You're amplifying the taxes vs. amplifying the tax-free growth," Kilday said.
Your timetable
James Smith, certified public accountant, says to ask yourself: "How many years from today until I start to get the money out?
"The more years I have, the more years there are for that money to build up even more money, which may overcome the tax difference," said Smith, managing partner at Smith, Jackson, Boyer & Bovard PLLC in Dallas.
Your heirs
Are you planning to leave money for your heirs?
Because there aren't mandatory distribution requirements with a Roth IRA, your beneficiaries can inherit the account tax-free, although estate and inheritance taxes still apply.
"If you're going to leave IRA assets to your children, it's the difference between leaving their children a house with a mortgage and a home without a mortgage," Kilday said. That's because you will have already paid the tax on the account.
The decision on whether to convert your IRA shouldn't be made until you've crunched all the numbers. And it shouldn't be done in a vacuum.
"Make sure you have the conversation in the context of everything else," Kilday said.
Then, Kilday said, ask yourself one final question: "How does it fit into my overall plan?"
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