IRA Conversion Window is Still Open
Posted August 12, 2011
IRA Conversion Window is Still Open
One of the incentives for high net worth individuals to convert a traditional IRA to a Roth IRA is no longer available. But others — including tax-free distributions from a Roth IRA — are still out there, leaving the window wide open for investors to make the conversion.
The sooner a conversion is completed, the sooner the tax-free growth can begin. But before making any commitments, investors should make sure they understand the benefits and the short- and long-term consequences of an IRA conversion.
No More Dividing Converted Taxable Income
The jump-start incentive that expired on Dec. 31, 2010, allowed any tax on the converted taxable amount to be divided evenly and reported in 2011 and 2012. This reduced the amount of income tax due at the time of the conversion. Beginning with 2011 conversions, the entire converted taxable income must be reported in the year of the conversion. The good news is that tax rates for 2011 and 2012 remain frozen at 2010 levels.
Also, the traditional IRA conversion option is still available for all taxpayers, including those with income of $100,000 or more. Up until Jan. 1, 2010, taxpayers in this high income category were not able to convert a traditional IRA at all.
Can Versus Should
Just because someone can make an IRA conversion, doesn't mean that they should. As with any other investment, the decision to convert a traditional IRA to a Roth IRA should consider:
- Current and future income and net worth
- Current and future tax rates
- The size of the investor's estate and the estate tax
- Projected need for IRA funds during retirement
- Who you want to ultimately receive the money, you or your heirs
Why Convert Now?
Most of the differences between traditional and Roth IRAs revolve around income tax.
The primary benefit of a Roth IRA conversion is that all earnings from a Roth IRA are completely tax-free, if distributions are made after a five-year holding period and the taxpayer is 59 1/2 or older. Distributions from a traditional IRA are taxable at any age (with the exception of distributions of nondeductible contributions) at the taxpayer's current tax rate.
Contributions to a traditional IRA may reduce taxable income today (depending on the taxpayer's income and other restrictions), but contributions to a Roth IRA will not. Instead, the tax benefits of a Roth IRA come at the other end, when withdrawals are not reported as income.
Another important note is that, although the income limit on converting a traditional IRA to a Roth IRA has been dropped, the income limit for contributing to a Roth IRA has not. For investors with modified adjusted gross income of $179,000 or more who want the benefits of a Roth IRA, conversion of a traditional IRA to a Roth IRA may be the only option.
Unlike a traditional IRA, the Roth IRA also has no minimum required distributions. The account owner can choose to use all, part or none of the funds for living expenses, or leave the account to heirs.
Who are Good Candidates for Conversion?
A traditional IRA to Roth IRA conversion is not for everyone. Every investor should talk to a qualified tax professional and financial planner before making any commitments.
Generally, good candidates for traditional IRA conversion might include:
- Persons who think they will not need their IRAs to supplement their retirement income
- Persons who expect to be in a higher tax bracket in retirement
- Persons who have sufficient cash or high-basis assets that could be liquidated to pay the income tax due on the conversion
- Persons who want to leave money to their heirs
- Persons whose estate will likely be subject to federal estate tax
- Young people who are still early in their work career and who can benefit from many years of tax-deferred growth, especially if they are currently in the lower tax brackets
Learn more about the pros and cons of traditional IRA to Roth IRA conversions.
