Prepare now for a 2010 Roth IRA conversion

In 2010, the $100,000 modified adjusted gross income limit to be eligible to convert a traditional IRA or qualified plan to a Roth IRA will be repealed, making everyone eligible for a conversion regardless of income.

This is great news for higher-income individuals and couples, who until now have been unable to convert an existing IRA or employer-qualified plan to a Roth. Also effective in 2010, a conversion to a Roth IRA is allowed regardless of filing status. Currently, married taxpayers who file separately are not allowed to make a Roth IRA conversion.

Why is a Roth IRA such a great deal?

Since its introduction in 1998, the Roth IRA has been a popular alternative to a traditional IRA. Here's why:

• Tax-free withdrawals. Instead of claiming a tax deduction up front, as one would with a deductible contribution to a traditional IRA, a Roth IRA offers tax-free withdrawals on the back end — as long as you leave the money in the fund for at least five years and are 59½ or older when you take distributions or meet another qualifying event, such as death, disability or purchase of a first home.¹
• Tax-free growth. Although you won't receive a tax break in the year that you make a conversion or contribution to a Roth, your money can grow tax free once it’s in the fund.
• No required minimum distributions. A Roth IRA has no required minimum distributions, unlike a traditional IRA, which requires withdrawals beginning at age 70½. So you can keep your money in the fund indefinitely and have complete control over when and how much you withdraw. And remember — withdrawals are tax free.
• Estate planning opportunities. A Roth IRA conversion can reduce the size of your taxable estate. In addition, because there are no required minimum distributions, you can eventually pass the full value of your Roth on to your heirs income tax free. Non-spouse beneficiaries can continue to accrue tax-free growth in an inherited Roth IRA, but they must take required distributions based on their own life expectancy.

Of course, there are factors to consider before you invest in a Roth. Talk to your financial advisor, who can help you evaluate this investment option.

Is a Roth IRA conversion a good idea in the current environment?

This may be the silver lining of the down market. Low stock market prices have reduced the value of IRAs and other qualified plans, including 401(k), 401(a), 403(b) and 457(b) plans.

If you make a conversion in early 2010, you will be taxed on the value of the investment at the time of conversion. Depending on what happens with stock prices between now and when you make the conversion, you may be paying taxes on a much lower value than you would have in an appreciating market. And once you’ve made the conversion, any future growth will be tax free (if qualifications are met) — another advantage in what many believe is a rising tax-rate environment.

How do I know if a conversion is the right choice for me?

As a rule of thumb, a Roth IRA conversion makes sense if you:

1. Have a long period of time until you need to access the funds (you need to hold the Roth IRA for at least five years before you can distribute any earnings tax-free but generally a longer period of time is necessary for the conversion to be advantageous);

2. Are in a lower tax bracket now than you will be when you or your beneficiaries access the money; and

3. Have assets available outside your IRA to pay the conversion taxes.

If you change your mind or your circumstances change, you can recharacterize your Roth IRA conversion back to a traditional IRA for any reason until Oct. 15 of the year following the conversion year and have no tax consequences. This gives you flexibility in the event the value of your investment declines after you convert or if your situation changes to the point where the Roth conversion no longer makes sense.

What are "conversion taxes"?

Because a Roth IRA conversion involves moving assets from a pre-tax IRA or qualified plan to a Roth IRA, the amount converted is subject to ordinary income tax. One advantage to converting in 2010 is that you can report income from the conversion on your tax return for the same year, or you can divide it equally on your 2011 and 2012 tax returns. This not only makes it easier to come up with the funds to pay the tax, but also may mean you will pay less tax.

Should I contribute directly to a Roth?

This is also an option; however, one thing that isn't changing for the Roth IRA in 2010 is the income limitations for people who make direct contributions. The income threshold for 2009 is $120,000 (phase out begins at $105,000) for single filers and $176,000 (phase out begins at $166,000) for married couples filing jointly. These income limits may increase for 2010 or later because of cost-of-living adjustments. For individuals who are not eligible to make a Roth IRA or deductible IRA contribution, funding a non-deductible traditional IRA and converting to a Roth IRA in 2010 and later years may be a good strategy. There are special tax rules associated with after-tax IRAs, so be sure to check with your financial advisor and tax advisor before utilizing this strategy.

What should I do now to prepare?

In order to benefit from this valuable retirement planning opportunity, you should take steps now. First, talk to your financial advisor to learn more about the Roth IRA and to determine if a Roth conversion is the right choice for you. Then, work with your advisor to determine what steps you can take to make the most of this opportunity in 2010.