A new opportunity has opened this year for many Americans who have traditional IRA accounts. As the Roth IRA moves to its teen years, the households with these accounts number approximately half of those with the much more mature traditional IRA accounts. Other than the 23 year head start that the original IRA has over the Roth version, the younger sibling lags behind because there have been many limitations on who qualified to contribute to them. So was this new opportunity worth waiting 32 months from when the law was passed to make a move? Why would anyone want to pay taxes sooner than necessary, regardless of the future benefits? It may actually make sense. Read carefully as this is quite complicated.

While there is still an income limitation on who can contribute to an individual Roth IRA ($167,000 to 177,000 for joint filers and $105,000 to $120,000 for others in 2010), since 2007 (assuming that your employer approves) you have been able to contribute your 401(k) or 403(b) income deferral to a Roth type of account. What’s new is that, beginning in 2010, everyone who has a traditional IRA can make a rollover contribution to a Roth account regardless of income. What’s more, there is a special “this year only” break to declare the income from the conversion as taxable either in 2010, or pay half in 2011 and half in 2012. So now that you know this opportunity exists, is it the right thing for you to do? Here are the basic issues to consider in making your decision.

 Reasons that you should consider making a conversion:

1. You expect to have higher tax rates in retirement years.
2. You expect your IRA portfolio to appreciate significantly in the next few years.
3. You have a decade or more before you plan to need or are required to take retirement funds.
4. A Roth IRA distribution has no income tax ever or early withdrawal penalty if you have reached 59 ½, or have held the account for at least five years from the first contribution.
5. You have a large percentage of your contributions of traditional IRA assets qualifying as after tax contributions.
6. There’s no requirement to make any distributions in your lifetime.

 Reasons to consider not making a conversion:

1. You expect to have lower tax rates in your retirement years.
2. You don’t expect your IRA portfolio to appreciate much in the next few years.
3. You’ll have to pay the income tax on the conversion from the IRA funds.
4. Your retirement date is only a few years away.

 Safety nets to give you flexibility:

 If you change your mind about having made a Roth conversion, you have until as late as October 15, 2011 to unroll the transfer by a re-characterization. (Tip – segregate each conversion into a separate Roth account to simplify the reversal.)

1. You can pay the tax on the conversion in full in 2010, or report half of the income in 2011 and the balance in 2012. By filing your return on an extension later in 2011, you should have a better picture of your future income tax rates before making a commitment.

 Other items you need to know:

1. Any qualified retirement plan can be rolled to a Roth IRA in certain circumstances.
2. There’s no guarantee that Congress will treat the Roth account so kindly in all future years. (Have you heard the discussion about means testing recently?)
3. By segregating your asset classes in different Roth accounts, you would have the opportunity to move declining assets back to the traditional IRA while leaving the high performing assets in a Roth.

 So what should you do? Obviously there are many variables in making such a decision, but you should give a conversion serious consideration, regardless of your current income tax situation or investment prognosis. With the opportunity to reverse your decision with limited negative impact, it seems to be a win-win decision in early 2010 in most situations. Also, remember that this isn’t an all or nothing rollover. A partial move toward a Roth may be your best option.

 Procrastination isn’t likely to do you any favors in this decision. There are many software tools to help with your computation based on your facts and assumptions. Contact us if you want to walk through a discussion of the wisdom of such a switch in direction for your retirement funds.

Filed under: Tax by Mark Patrick