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Should you convert to a Roth IRA now?

by on
in Small Business Tax

Is converting a traditional IRA to a Roth this year a good idea? It de­­pends on the situation.

Strategy: Weigh the pros and cons. Although taxpayers no longer can benefit from a special tax break for conversions in 2010, converting to a Roth still might be a smart tax move. Of course, the conversion is subject to current income tax.  

The conversion technique often makes sense for high-income tax­payers who expect to be in the same or a higher tax bracket in retirement.

Here’s the whole story: The main advantage that Roth IRAs have over traditional IRAs is that qualified distributions from a Roth in existence at least five years are completely exempt from tax. This includes distributions made after reaching age 59½, on account of death or disability or to pay first-time homebuyer expenses (up to a lifetime limit of $10,000). In contrast, distributions from a traditional IRA are taxable at ordinary income rates.

Also, you don’t have to take re­­quired minimum distributions (RMDs) from a Roth IRA during your lifetime. With a traditional IRA, RMDs must begin after age 70½.

Why haven’t more taxpayers converted to a Roth? Prior to 2010, tax­payers weren’t permitted to convert in a year in which their modified ad­­justed gross income (MAGI) ex­­ceeded $100,000. But the $100,000 barrier was removed last year.

One-time tax break: For conversions occurring only in 2010, you could choose to split the taxable income resulting from a conversion over the following two years—2011 and 2012. This usually provided income tax savings plus tax deferral.        

The deadline for this dual tax winner has come and gone, but that doesn’t mean other potential tax savings should be ignored.

Example: Spread out tax liability

Let’s say that Gwen Olsen is a joint filer earning $150,000 a year. She has $500,000 in a traditional IRA. Gwen is currently in the 28% tax bracket, but expects to be in the 35% tax bracket when she retires in 20 years.

Assuming a 6% return, an online calculator shows that Gwen will have $1,137,051 in her account at retirement if she converts to a Roth in 2011. Conversely, if she keeps the funds in a traditional IRA, she’ll have $1,032,530 in 20 years, or $104,521 less.

But remember that Gwen still has to come up with the cash to pay her current tax bill of $167,302. If it suits her needs, she can convert only part of the $500,000 balance in her ­traditional IRA or use some of the IRA funds to pay the tax bill (although this reduces the overall tax benefit).

The extra taxable income triggered by a Roth conversion is added to ordinary income from other sources (e.g., salary, self-employment income, short-term capital gains, etc.). Therefore, if you convert an IRA with a large balance, it could push you into an even higher tax bracket. The conversion income might also affect other aspects of your tax return (e.g., education credits and other tax breaks that are based on AGI).

Another approach: Convert half of the traditional IRA this year and the other half next year. This division may avoid extra tax liability and the loss of other tax return benefits.

In effect, you’re spreading out the tax liability over two years, similar to the tax break allowed for conversions in 2010.

Tip: No matter what, taxpayers have until Oct. 15 of the following year to recharacterize a conversion. That gives you until Oct. 15, 2012, to undo a conversion made in 2011.

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