2010 may be the time for you to convert to a Roth

Roth IRAs, a wonderful retirement-planning tool currently unavailable to high earners, will be available to you regardless of your income starting in 2010. But Roths aren’t right for everyone. Here’s what you need to know about the new Roth eligibility rules — and how to decide if they’re right for you…

THE NEW ROTH CONVERSION RULES

Roth IRAs have some real advantages when it’s time to take money out — all Roth withdrawals are tax free after five years* if you are at least 591/2, and unlike with a “traditional” IRA, with a Roth there are never any required minimum distributions (RMDs). Unfortunately, Roth rules have made it difficult for high earners to get their money in. Those with modified adjusted gross incomes (MAGIs) of more than $120,000 ($176,000 for couples filing jointly) cannot contribute to a Roth in 2009… and households with MAGIs of more than $100,000 cannot convert traditional IRAs to Roths.

That’s changing next year and thereafter. The income restriction on conversions will disappear. Also, for 2010 only, those who make conversions can split the resulting taxes — converted dollars are taxed as income — between tax years 2011 and 2012, delaying and dividing the bill.

CONVERSION CANDIDATES

Who should convert some or all of their traditional IRA savings to Roth IRAs? Converting makes the most sense for…

Young people. Those still in their 20s and 30s almost certainly should convert, and those in their 40s most likely should, too. Young people’s savings will enjoy so many years of tax-free growth in a Roth that they’re virtually certain to come out ahead after taxes.

Those currently unemployed or underemployed. If the recession has taken a big bite out of your income, it’s the perfect time to convert a big chunk of your traditional IRA to a Roth. Your lagging income may place you in a lower tax bracket, which means lower taxes on converted dollars.

  • Caution: Don’t dip into your IRA savings to pay your conversion tax bill. Not only would this cost you years of tax-free gains on the money withdrawn, but you would also face a 10% early withdrawal penalty if you’re younger than 59½.

Those whose traditional IRAs have suffered big losses. The further the value of your IRA has fallen, the lower the tax bill for converting it to a Roth.

Those focused on leaving as much as possible for their heirs. Roth IRAs have no RMDs during your lifetime (although other than in 2009, heirs must take RMDs), so they’re a great way to leave assets to heirs. The heirs won’t face income taxes when they withdraw this Roth money, either.

Those who currently have no Roth assets. Every retiree should have some assets in either a Roth IRA or Roth 401(k).

  • Reason: Those with no Roth savings have limited tax-planning flexibility during retirement — no tax-free assets to live off in high-bracket years.

WHO SHOULD NOT CONVERT

If you already have Roth savings, converting a traditional IRA to a Roth IRA might not be a smart move if…

You’re still working and are at or near your peak earning level. If your tax bracket in retirement is likely to be significantly lower than your tax bracket today, it might be wise to leave your savings in a traditional IRA. If you converted to a Roth, you would have to pay taxes on this savings at your current high rate. However, it still might be worth making the conversion if you believe that the government is likely to significantly raise income taxes on people in your future retirement tax bracket in the coming years, a valid concern.

You’re only a few years from retirement. The less time your investments have to grow before they’re withdrawn, the less appeal a Roth has. The big benefit of a Roth is that your investment profits don’t face income taxes. If you take your money out quickly, your investments are unlikely to have profited much. Also, removing money from your Roth within five years of a conversion could trigger penalties.

IRS rules govern distributions from a Roth. First distributions out are contributions… next are conversion dollars on a first-in, first-out basis… and last out are earnings. Contributions and conversions always come out tax free.

If you’re not certain whether a conversion is right for you, speak with your financial adviser or try the online Roth Calculator offered by Convergent Retirement Plan Solutions, LLC, a retirement-services company that works with investment advisers (www.rothretirement.com/calculator.html). The calculator will estimate how much you would benefit financially by making Roth conversions of various sizes.

MAKING THE MOST of A ROTH CONVERSION

Three ways to maximize the benefits of your Roth conversion…

Convert only up to the top of your current tax bracket. Converting so much that you push yourself into a higher bracket or trigger the alternative minimum tax (AMT) reduces the benefit of the conversion.

  • Strategy: Wait until future years to convert any IRA dollars remaining after you reach the top of your current bracket — unless your rising income makes it likely that you would be in an even higher bracket in future years.

Increase your after-tax/pretax IRA ratio before making conversions. Taxpayers who have contributed both pretax (deductible) and after-tax (nondeductible) dollars to a traditional IRA cannot avoid a tax bill by converting only the after-tax dollars into a Roth IRA. If you have both pretax and after-tax savings in IRAs, you must pay taxes on the percentage of your conversion equal to the percentage of your household’s total traditional IRA savings that are pretax dollars.

  • Example: If you have $20,000 in after-tax IRA contributions and $180,000 in pretax IRA contributions, you will have to pay taxes on 90% of your Roth conversion.
  • Strategy: Make as large an after-tax IRA contribution as possible in the year(s) before the year in which you intend to make your Roth conversion, to improve your after-tax/pretax ratio and reduce your conversion tax bill. Don’t roll a 401(k) to an IRA until after converting your traditional IRAs into Roths — 401(k) rollovers often are big blocks of pretax dollars that could substantially lower your after-tax/pretax ratio. If you already have a rollover IRA, try to roll it back into a 401(k) before your conversion, to bring your ratio back to where it was before the conversion.

Take advantage of Roth IRA conversion “do overs.” If the value of the investments you convert to a Roth IRA decreases between the conversion date and October 15 of the following year, switch (“recharacterize”) the Roth back to a traditional IRA. That way, you won’t have to pay income taxes on a high asset value that no longer exists. You can reconvert the assets to a Roth again in a future year.

  • Strategy: Open new Roth accounts for each conversion, or even separate Roth accounts for each type of IRA investment converted — say, one for equity investments and another for fixed-income investments — so that you can recharacterize only assets that decline. Combine your Roth accounts after the recharacterization window closes to avoid unnecessary account management fees.

*With a standard Roth, the five-year clock starts ticking at the beginning of the tax year in which you make your first Roth contribution, no matter how many additional standard Roths you create. In contrast, with a Roth conversion, the five-year clock starts ticking on the converted account in the tax year that each conversion is made.