Thanks to the Pension Protection Act of 2010, many IRA owners with incomes over $100,000 will be able to convert their Traditional IRA to a Roth IRA. Unfortunately, most investors are not aware of this upcoming delight.
In a Traditional IRA, the contribution of current year is tax deductible, and grows tax-deferred, meaning you pay taxes as ordinary income when you take the IRA money out, after you achieve the age of 59 ½. While a Roth is not current year tax deductible, the growth and withdrawals are federaly tax free. Further, there are fewer limits on withdrawals from a Roth IRA. Withdrawals can be made after the account has been held for five years and when the account holder has turned 59 ½, or using the withdrawal to buy a first home (with a $10,000 limit). While mandatory withdrawals start with Traditional IRA’s at age 70 ½, there is no mandatory withdrawal schedule for Roth’s. Withdrawals taken before the age of 59 ½ will incur a penalty by Uncle Sam.
Who should convert? While there is no rule of thumb, if you are at least 10 years from retirement, anticipate a higher tax rate in retirement or plan to leave savings to their estate or heirs, they should consider a conversion. The downside? You have to take the Traditional IRA’s conversion value as income in the current year of 2010, but the tax laws will allow you to spread the tax payment over a two year period if it is converted in 2010.
If your intention is to leave all or a part of your Traditional IRA to a charity, leave it in the Traditional format- the charity does not pay any taxes on withdrawals.
Surveys show most investors do not fully understand the ramifications of the conversion process, or the taxation of the various forms of IRA. This blog is by no means a full explanation- consult your financial planner for all the rules concerning your conversion, or if it is viable for you.
