There has been a lot of discussion about the potential benefits of converting from a traditional IRA to a Roth IRA, spurred on by new rules that go into effect in 2010. Starting next year, the $100,000 income ceiling will be eliminated and married individuals filing separately will be allowed to convert a traditional IRA to a Roth IRA.

Determining whether you should convert can be a complicated and difficult decision. You must weigh the benefits against the income tax consequences and other potential drawbacks.

Here’s a quick rundown of advantages of converting:

- Qualified distributions from the Roth IRA will be completely tax free

- For nonqualified distributions from the Roth IRA, the portion of the distribution that represents your contribution is not taxable

- You do not have to take required minimum distributions from the Roth IRA after age 70½

- If you use non-IRA funds to pay the income tax that results from rolling over or converting funds to a Roth IRA, those funds are removed from both your taxable estate and your countable assets

- Qualified distributions from Roth IRAs are not counted in determining the taxable portion of your Social Security benefits

- Individuals in a low income tax bracket (i.e. 15% tax bracket) can calculate the ideal conversion amount in order to maximize the benefit of their lower income tax rate

- There is a special tax incentive for those who choose to convert during 2010 — the option to include the taxable portion of any 2010 conversions in taxable income for 2011 and 2012.

And some disadvantages:

- Funds that you convert or roll over from a traditional IRA to a Roth IRA are subject to federal income tax, to the extent that such funds represent investment earnings and tax-deductible contributions to the traditional IRA

- Using IRA funds to pay the resulting income tax (the “conversion tax”) has significant drawbacks

- Special penalty provisions may apply to withdrawals from Roth IRAs that contain funds converted or rolled over from traditional IRAs

- The taxable income that results from converting funds can increase the taxable portion of your Social Security benefits

- There always exists the risk of future changes in federal law governing the taxation of Roth IRA distributions

There is one last tactical consideration to keep in mind with regard to the decision to convert. Individuals may “recharacterize” (i.e. undo) the Roth IRA conversion in the current year or by the filing date of the current year’s tax return. For example, an individual can convert their IRA in January 2010 and decide to recharacterize their conversion as late as October 2011; in other words, the individual has approximately 21 months to determine if it makes investment and/or tax sense to do the conversion. This powerful tool essentially provides individuals with an ability to “see into the future” before making a final decision about their IRA conversion!

Despite the potential benefits of a conversion, the rocky markets of the past two years have resulted in a general hesitancy on the part of investors to pay taxes in advance or to make any drastic changes in their investments, as noted in this Investment News article. Time will tell if that reluctance will fade with more education on the subject, but it is something all of us need to begin thinking about as 2010 approaches.

This entry was posted on Monday, November 16th, 2009 at 10:08 am and is filed under Wealth management. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.