By Tom McDavitt

You may have heard the buzz about the opportunity to convert your Traditional IRA to a Roth IRA regardless of your income level in 2010 ~ and this buzz might have you asking whether it’s as good an idea as some financial firms are professing it to be. Well, that depends. Certainly, it would be prudent to start with a conversation with your financial and/or tax advisor, but here is some food for thought in advance.

What are the strengths of a conversion? Let’s start with the universal appeal of tax free qualified withdrawals from the Roth. Who doesn’t get excited about that, especially if you will be in a higher tax bracket when you withdraw from the account.

Another positive is that Roth IRAs are not subject to annual required minimum distributions. If you don’t need the income and prefer not to receive the taxable income each year, then you may be a reasonable candidate for conversion. Also, qualified distributions from the Roth are not included when determining the taxable portion of your Social Security.

However, there are some caveats to consider. First, the converted amount is taxable ~ normally in the year of the conversion, but there are special rules for 2010 conversions which we will discuss below. There are a few other issues to consider as well. For example, you still have to have the Roth IRA in place for 5 years to qualify for tax free status, but what if you have already reached age 59 ½? In that scenario, if you are using your IRA to fund annual expenses now, then you would have to pay taxes on the withdrawals until the 5-year rule is satisfied, unless of course you have an existing Roth IRA that was established for tax year 2005 or earlier. In that case, you have already met the 5-year part of the equation.

What are some of the issues to dissuade you from a conversion? One frequently overlooked consideration is the source of the funds with which you’ll pay taxes due upon conversion. If using IRA dollars is the only way that you can pay the conversion tax, then you substantially reduce the attractiveness of the conversion. You could do damage to your long term retirement goals by reducing the funds you own. If possible, it is best to fund the taxes with non-IRA assets.

Furthermore, if you are receiving Social Security benefits in the year you convert, you must be aware that since the conversion creates taxable income, you may have to pay more income tax on your Social Security income in the year you report the conversion.

As mentioned earlier, there are special rules for conversions made in 2010. The amount that must be included as income can be pushed forward to 2011 and 2012. You must report 50% each year as income. Sounds great, doesn’t it? Yes, it does, but please be aware that tax rates may rise after 2010 ~ most notably for people with incomes over $250,000 (including conversion amounts) ~ as the Bush tax cuts expire. There could be a substantial expense involved in the strategy.

The bottom line of this discussion is that one should not boldly move ahead with a conversion without a thorough examination of its merits with an advisor.

Thomas J McDavitt, McDavitt Wealth Management 102 Shore Drive. Worcester MA 01605
(508) 852-6222, (800) 539-8517, Tom@cmfin.com

Securities and Advisory Services Offered Through Commonwealth Financial Network, Member FINRA/SIPC, A Registered Investment Adviser

This entry was posted on Wednesday, March 3rd, 2010 at 4:43 pm and is filed under ParentCare, Vol. 14. 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.