InvestingAn Opportunity to Convert to a Roth IRA in 2010
If you have ever heard me speak on tax or wealth strategies, you've probably heard me say that I am not a big fan of 401(k)s or IRAs.
One of the reasons I am not a big fan of Traditional IRAs and 401(k)s is because they only defer tax. While tax deferral can be helpful in a tax and wealth strategy, the best type of tax planning is tax elimination which creates permanent tax savings.
This often leads to the question: What about a Roth IRA? If I have to pick between a Roth IRA and a Traditional IRA, I'll usually go with the Roth IRA.
Tax elimination v. tax deferral is why I tend to prefer Roth IRAs over Traditional IRAs. While contributions to a Roth IRA are not deductible, the income and distributions from a Roth IRA are never taxed (provided they meet certain rules). This creates permanent tax savings.
When I meet with new clients, they usually have a Traditional IRA and no Roth IRA. So, one of the options we explore for future permanent tax savings is converting the Traditional IRA to a Roth IRA.
There are several factors to consider when deciding whether to convert a Traditional IRA to a Roth IRA. One very important factor is that the conversion of a Traditional IRA to a Roth IRA is considered a taxable distribution, and is taxed as ordinary income at your marginal tax rate.
Take the Tax Hit Now or Later? This then raises the question: Is it better to take the tax hit now and permanently eliminate tax on all future earnings and distributions from the Roth IRA or allow the deferred tax to continue to grow in the Traditional IRA?
Sometimes the answer depends on how long there will be earnings inside the IRA, or how much time there is before distributions are taken. Other times, the answer is influenced by what is going on outside of the IRA, such as if there are losses available to offset the conversion income so no tax is paid.
There are definitely situations in which converting makes sense. But, many times, taxpayers don't even have the option to convert due to IRS restrictions on who can convert a Traditional IRA to a Roth IRA.
Who Can Convert to a Roth IRA? Currently, only individuals with modified adjusted gross income (this is essentially your income from all sources with a few adjustments) of $100,000 or less can convert their Traditional IRA to a Roth IRA. In addition, married taxpayers filing separate returns are currently prohibited from converting their Traditional IRA to a Roth IRA.
However, beginning in 2010, these income and filing status restrictions are completely eliminated! This special treatment gives everyone, regardless of income level or filing status, the opportunity to convert a Traditional IRA to a Roth IRA.
It Gets Even Better in 2010, 2011 and 2012 In 2010, individuals will have the choice of recognizing their conversion income in 2010 or averaging it over 2011 and 2012.
The averaging option allows the taxes on the converted amount to be paid over two years, instead of recognizing it all as income in one year. Keep in mind though that the deferred amount will be taxed at the rates in effect for 2011 and 2012, which may be higher than the rates in 2010.
Should You Consider Converting? A few things to take into consideration include:
The cash outlay required to pay the taxes on the converted amount Your projected income in 2010, 2011 and 2012 Your projected marginal tax rate in 2010, 2011 and 2012 The tax-free nature of distributions from a Roth IRA The amount of time remaining to allow assets in the Roth IRA to grow tax-free The amount of time before distributions are taken
As you can see, the decision to convert your IRA requires short-term planning as well as long-term planning. The long-term planning can have a significant impact on your estate and the amount of wealth you pass to your heirs.
2009 is the Time to Start Your Planning If you plan on converting, then now is the time to start planning because your 2009 tax planning may look a little different. For example, you may want to defer deductions until 2010 and accelerate income into 2009 to avoid being pushed into higher brackets in 2010, 2011 or 2012 from large conversion income.