Demystifying Roth Conversion

Stuart M. Gladstone and Bonnie Leibowitz-Carchi Lately it is hard to miss all of the literature concerning conversion from a traditional IRA to a Roth IRA. Even after being bombarded with loads of information, you may still ask: Is a Roth Conversion right for me? Although the determination needs to be made on a case-by-case basis, first you need to consider a few basic questions.

How is a Roth IRA different from the traditional IRA? With a traditional IRA, pre-tax dollars fund the traditional IRA, but when a distribution is made, the money is subject to tax at ordinary rates (both the initial contribution and earnings thereon). The benefit of the traditional IRA is tax deferral. The tax will come due when a distribution is made. The hope is to be in a lower tax bracket when the money is distributed to the taxpayer in retirement. For a Roth IRA, money is contributed on an after-tax basis, but the monies (both the initial contribution and any earning thereon) can be distributed free from tax later if certain conditions are met. In addition, unlike a traditional IRA where the taxpayer must begin taking distributions at age 70½, the Roth IRA has no required minimum distributions while the owner is alive. If the spouse is named as the sole beneficiary, then no minimum required distribution will be required while he or she is alive. This allows for more tax-free compounding.

Why all the hype? Prior to 2010, taxpayers in higher income tax brackets could not convert to a Roth IRA because of the income limitations. The prior law only allowed conversions for individuals and married taxpayers (filing jointly) whose adjusted gross income was $100,000 or less. Under the Tax Increase Prevention and Reconciliation Act (TIPRA), this limitation is removed in 2010 and for subsequent years. Now, as a result of the change in the law, higher income taxpayers may convert the traditional IRA to a Roth IRA. There is a catch, however. If you desire to convert your traditional IRA to a Roth IRA, it will trigger federal income tax. You will pay tax on any contributions that were made on a tax-free basis as well as any earnings thereon of the amount converted. You can pay one-half of the tax due with your 2011 return and the other half with your 2012 return for conversions done in 2010 ONLY. If you convert in any year after 2010, then you must report and pay all of the tax due in the year of conversion. In any event, you should pay this amount with monies outside your IRA; otherwise you may be subject to a penalty.

Taxpayers with ample funds to pay the tax from assets outside the IRA, those who do not anticipate needing the funds in retirement, and those who do not anticipate being in a lower tax bracket later in life are typically good candidates for a Roth conversion. The money then stays in the Roth IRA and grows tax free.

What if you change your mind? Your converted IRA drops significantly in value and you are faced with a huge income tax bill. You can recharacterize your Roth back to a traditional IRA as if it never happened. You can even wait until October 15, 2011 to change your mind if you put your 2010 return on extension.