Is a Roth IRA conversion right for you?

The income ceiling and filing status requirements for Roth IRA conversions will be eliminated in 2010 — great news for many investors. But before you convert your existing IRA or employer-qualified plan to a Roth IRA, make sure this option is right for you.

When a Roth IRA conversion makes sense

While there's no "one size fits all" answer, a Roth IRA conversion makes sense if:

• You won't need to access the money in the account within the first five years after you establish the Roth IRA. Keep in mind that although five years is the minimum required for tax-free withdrawals, a longer timeframe is usually necessary for a conversion to be most effective.
• You can pay the tax due on the conversion without having to draw money out of the original IRA or employer-qualified plan to make the payment.
• You're in a lower tax bracket than the one you expect to be in when you retire.
• You want to build an estate for your heirs and minimize the overall tax burden for your family.

Are you a good candidate for a conversion to a Roth IRA?

It depends on your tax rates today versus what you expect them to be in the future. But here are just a few of the individuals who could benefit from a Roth IRA conversion:

• Women who are married and nearing or in retirement. In general, women live longer than men — an average of three years longer. But if you outlive your husband, yet continue receiving the same amount of income (e.g., from a joint life pension plan), you could end up in a higher tax bracket when your filing status changes to single.

  With a traditional IRA account, a higher tax bracket would result in higher taxes on your withdrawals. But with a Roth IRA, your withdrawals are tax-free once the five-year holding period is met and you reach age 59½. So a tax-bracket change would have no impact on the account.

• Men. The same logic applies to men. If you are a widower, any income you continue earning on behalf of your spouse could potentially bump you into a higher tax bracket. But with a Roth IRA, your tax bracket is irrelevant because qualified withdrawals from this type of account are tax-free.

• Anyone who wants to leave a financial legacy. There are a number of benefits to using a Roth IRA to build an estate to pass on to your heirs:

  • Reduce the taxable portion of your estate. When you convert an existing IRA or qualified plan to a Roth IRA, you’ll potentially reduce the taxable portion of your estate when you pay the taxes up front.

  • Share your legacy with your loved ones, tax and penalty free. Your beneficiaries will receive the total value of your account without having to pay any income taxes or penalties. In fact, the only income taxes they would potentially need to pay would be on any distributions of earnings they receive prior to the five-year holding period (from the date you originally established the account or made the conversion).

• Anyone who wants to take advantage of these additional benefits. A Roth IRA offers a few benefits that are not available with a traditional IRA or employer-qualified plan. These include:

  • Tax-free growth with no RMDs. Once the Roth IRA is established and the up-front taxes have been paid, your money in the account grows tax-free. Plus, there are no required minimum distributions (RMDs), so all your money can remain in the account. This means you can grow your total account value over a longer period of time, which could result in more significant retirement savings for you, or increased benefits for your beneficiaries. In contrast, a traditional IRA requires annual distributions once you reach age 70½. And failing to take these distributions on time and in full results in an Internal Revenue Services (IRS) penalty — 50% of the amount that should have been taken. A Roth IRA has no such penalty.

  • Option to contribute to your account as long as you like. With a traditional IRA, you can no longer contribute to your retirement account once you reach age 70½ — even if you're still earning income. But with a Roth IRA — even one that was converted — you can continue making contributions regardless of your age, as long as you have earned income from a job and meet the other qualifications. Certain restrictions apply, so ask your advisor for details.

  • Tax-free withdrawals. While you grow the account for your heirs, you can also access it when you want to without paying taxes on withdrawals, as long as you’ve kept the assets in the account for at least five years and you’ve reached age 59½. (Withdrawals from traditional IRA and employer-qualified accounts are typically taxed as income.)

    You can also draw money from the account tax-free if you reach a different qualifying event such as a disability, or if you meet the requirements for a first home purchase. Tax-free withdrawals in the future are especially appealing when considering the potential for taxes to rise in coming years.

Clearly, a Roth IRA conversion can benefit many types of investors. And combining this type of account with other retirement savings plans, such as traditional IRAs and 401(k)s, can help ensure you have a well-rounded portfolio for retirement. Here are some additional considerations to help you make a decision.

Roth IRA contributions

If you qualify, you can also grow your retirement savings with Roth IRA contributions. But keep in mind that while restrictions are waived for Roth IRA conversions in 2010, the limit on contributions will remain in place. Specifically, to make a full contribution in 2010, you must have a modified adjusted gross income (MAGI) of less than $105,000 if you’re single, or less than $166,000 if you’re married and filing a joint return (actual 2010 MAGI limits have not yet been released, so these figures could change). Also, if you’re married and filing separately, you won’t qualify for a Roth IRA contribution unless your MAGI is less than $10,000. This is why a Roth IRA conversion, which has none of these restrictions in 2010, is so appealing.

If your income is too high to make a Roth IRA contribution and you're not eligible for a deductible IRA, you can opt to fund a non-deductible traditional IRA and convert to a Roth IRA in 2010 or later. The after-tax contributions are not taxable when you do a conversion. But be careful with this strategy if you have other pre-tax IRA assets as special tax rules apply. Consult your tax advisor.

Why 2010 is the opportune time for a conversion to a Roth IRA

There are a number of unique opportunities that make a Roth IRA conversion especially appealing in 2010:

1. You can postpone your tax payment. If you convert in 2010, you'll be able to spread taxes over a two-year period, splitting the payment equally on your 2011 and 2012 income tax returns. This can make it easier to pay the tax.

A word of caution: If income tax rates go up in 2011 or 2012, your total tax payment could actually increase by spreading the taxation over the two-year period, so you may benefit by paying the income tax on the converted assets in 2010. Talk to your tax advisor to determine when you will need to make estimated tax payments.

2. The tax on the conversion may be lower in today's market. If you have investments in an IRA or other qualified plan that have lost value, you'll only pay tax on the amount you convert. This means as the investments recover, growth will be tax-free (if you meet certain holding-period requirements) and you could actually benefit from the market downturn.

3. Your assets will have more time to grow tax-free. By taking advantage of this conversion opportunity as soon as it's available, which for many investors is in 2010, you'll have more time to grow your Roth IRA assets. And with a Roth IRA, your invested dollars continue to grow tax-free without required distributions.

How a conversion works

Converting to a Roth IRA involves moving assets from an IRA or an employer-qualified plan to a Roth IRA. If the assets you convert are pre-tax contributions, they'll be subject to ordinary income tax the year you convert. You'll need to pay the tax at the time you convert or report it on your tax return. If you convert in 2010, you can choose to postpone the tax payment and split it equally on your 2011 and 2012 income tax returns, or pay it all on your 2010 income tax return.

A tax-free conversion opportunity

Converting a qualified plan to a Roth IRA presents special advantages if you have after-tax money in a 401(k) plan. You can roll over your pre-tax contributions and earnings to a traditional IRA and convert your after-tax assets to a Roth IRA tax-free. However, if you first rolled your after-tax assets to a traditional IRA, different rules apply. Also, if you have investments in employer stock, you should consult your tax advisor before converting to a Roth IRA or rolling to a traditional IRA.

What if you change your mind after the conversion?

You can reverse a conversion, perhaps because the value of your Roth IRA account dropped or you’re unable to pay the tax. You generally have until Oct. 15 of the year following the conversion to recharacterize back to a traditional IRA. For example, if you make a conversion in February 2010, your Roth IRA can be recharacterized back to a traditional IRA up until Oct. 17, 2011 (Oct. 15 is on a Saturday). This removes any tax consequences you would have incurred with the Roth IRA conversion.

However, if you intend to reconvert, you may not do so until the later of Jan. 1 of the year following the year in which the original conversion took place or 30 days after the recharacterization. Thus, if you recharacterize a 2010 conversion, you will not be able to reconvert until 2011 and will therefore not be able to spread the income taxation over the two-year period.

With its tax-advantaged savings and distributions, a Roth IRA is an excellent addition to any retirement plan. Talk to your financial advisor to learn more about the Roth IRA and determine if a conversion is the right choice for you.