Since the Roth IRA was first introduced, there have been rules in place that prohibited those with annual incomes above $100,000 to convert traditional IRAs to Roth IRAs. However, former President Bush signed a law in 2006 modifying the original rules which allows these individuals to convert their Roth IRAs starting in 2010. In addition, those who perform a Roth IRA conversion in 2010 will receive an extra tax advantage.
When a traditional IRA is converted to a Roth IRA, the accountholder will be taxed at ordinary income rates on the amount converted. So if a $50,000 traditional IRA is converted in the same tax year, the taxpayer will be taxed on an additional $50,000 of ordinary income. However, for conversions that take place in 2010 only, the IRS is allowing the taxes to be spread out over two years rather than having to be fully paid in 2010. This is great news for those that cannot afford to pay the taxes all at once, but there is a caveat. If tax rates rise in 2011, which just about everyone expects, the total amount that will have been paid over the two-year period will be greater than if the taxes were paid in the same year.
Let’s look at some examples:
Example 1
Let’s say you have a traditional IRA that you’ve funded with $20,000 of pre-tax contributions during the past 10 years and the current balance is $26,000. If you convert the full value of this account in 2010 and elect to spread the tax over two years, you’ll pay tax on $13,000 in 2010 and another $13,000 in 2011.
Example 2
Let’s assume you have a traditional IRA that’s been funded with after-tax contributions because you weren’t eligible for a deduction due to income limits. In total you’ve contributed $30,000 to the account and it’s worth $37,000 currently, so there’s an unrealized gain of $7,000. Since you’ve already been taxed on the $30,000 of contributions made, you would only be taxed on the $7,000 gain when you convert.
Although it might be exciting to now have the opportunity to convert your traditional IRA without an income restriction, keep in mind Roth IRAs are not necessarily right for everyone. For example, if you expect to be in a lower tax bracket in retirement than you are today, converting to a Roth IRA might not make sense. That being said, there are also plenty of advantages with the Roth IRA. For example, unlike a traditional IRA, there are no required minimum distributions starting at age 70. Since everyone’s situation is unique, it’s best to consult with one of our financial advisors, and a tax professional, before deciding if a conversion is right for you.