Posted 07.26.2010

Roth conversion could be for you

The rules have changed

By Sarah Marks

January 2010 ushered in major changes in tax laws governing individual retirement accounts (IRAs) – changes that some commentators believe create unprecedented financial-planning opportunities.

Prior to 2010, eligibility to convert a traditional IRA to a Roth IRA was subject to strict income limitations. Now, under current law, Roth conversions are available to people of all ages and income levels.

Basics of Roth IRAs

Like traditional IRAs, Roth IRAs provide a tax-efficient investment vehicle for retirement funds. However, unlike contributions to traditional IRAs or 401(k) plans, contributions to Roth IRAs are not tax-deferred. Amounts contributed to a Roth IRA are not deductible from gross income; once the initial tax is paid, however, the assets in a Roth IRA will grow tax-free. Qualified distributions from the account will also be tax-free. For qualified distributions, the accumulated earnings are never subject to tax.

Another attractive feature of Roth IRAs is that the account owner does not have to take required minimum distributions (RMDs) during his or her lifetime, as would be required of traditional IRA owners who have reached age 70½. In other words, the Roth IRA owner does not have to withdraw a minimum amount from his or her Roth IRA each year after reaching a certain age, and the assets can continue to grow and compound tax-free. Roth IRAs are subject to RMDs after the death of the account owner, but such distributions to heirs will also be tax-free.

Tax and Estate Planning Implications of Roth Conversions

When a traditional IRA is converted to a Roth IRA, the entire conversion amount is subject to income tax as if it were a distribution from the IRA. Depending on the value of the account, this income tax burden could be significant. However, if the account owner is able to offset this taxable income through the use of charitable deductions, net operating losses, individual tax credits and other tax means, then a Roth conversion could be an excellent tax-planning strategy.

While young, high-wage earners who can allow their Roth IRA assets to grow tax-free for a long period of time are great candidates for Roth conversions, Roth conversions provide an advantageous tax-planning and estate-planning tool for people of all ages. The effectiveness of a Roth conversion is enhanced if the account owner is able to use “outside” (non-qualified) assets to pay the conversion tax and, thus, keep as much money as possible growing in the Roth IRA. A conversion is further enhanced if the account owner does not need to use the assets for future living expenses and can allow the maximum amount of Roth assets to pass to the next generation.

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Last updated on Jul 22, 2010 at 06:15 PM

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