Should I convert my traditional IRA to a Roth IRA? |

Continuing this year, all holders of a traditional IRA will be eligible to convert their existing IRA to a Roth IRA, regardless of their income level or marital filing status. In effect, this allows taxpayers to lock in the current lower income tax rates on depressed account values. This article analyzes who should take advantage of this opportunity.

Traditional IRAs

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In a traditional IRA, the taxpayer makes contributions to an IRA account and receives an income tax deduction in the year of contribution. Thus, the traditional IRA is normally funded with “pre-tax” dollars. However, deductions are phased out based on income levels.

If the taxpayer has only made deductible contributions, then the entire amount of any distribution is taxed at the taxpayer’s then marginal income tax rate. If the taxpayer has made after-tax contributions, then a formula is used wherein a portion of the distribution is a tax-free return of capital and the rest is included in income. It is important to note, however, that the tax-free portion does not grow; it will be the same amount contributed regardless of the performance of the IRA. The traditional IRA also mandates required minimum distributions (RMDs) to a taxpayer starting no later than April 1 of the year after he/she attains the age of 70 1/2. Once RMDs start, the taxpayer has reached the statutory age limit and can no longer make contributions to an IRA.

Roth IRAs

In contrast to the traditional IRA, when using a Roth IRA, the taxpayer does not get a deduction on his or her income tax return for contributions; meaning the contributions are in “after-tax” dollars. The upside to the lack of current deductions in the Roth is that qualified distributions are tax-free. In addition, the Roth IRA does not mandate RMDs, so if the taxpayer does not need a distribution, contributions continue to grow tax-free in the account. Also, there is no age limit on making contributions to a Roth IRA, so the taxpayer could continue to make contributions as long as he is alive and within the contribution limitations. One of the few drawbacks of the Roth IRA is that the Roth IRA account must be open for five years before withdrawals can be made without penalty.

Benefits of Conversion

· You can hedge the current low income tax rates against increases that may come in the future. Currently, the highest marginal tax rate is 35%, but this is due to increase to up to 44% in 2013, and could possibly go higher, depending on legislation before Congress. If you are in the highest tax bracket currently, and foresee remaining in the highest tax bracket throughout your retirement, a conversion will lock in the lower current tax rates.

· Unlike traditional IRAs, Roth IRAs do not have mandates for required minimum distributions (RMDs). If you do not foresee a need for distributions during your retirement (because of sufficient other income-producing assets), there is really no need for distributions from the IRA. Each distribution loses tax-free growth otherwise afforded in the account.

· Beneficiaries who inherit any undistributed portions of the Roth IRA will not have to include distributions in their taxable income. In addition, if you do not take distributions, the amount given to beneficiaries could be much greater than if RMDs were required. Because of these two factors, the potential return for all beneficiaries is much greater for a Roth IRA than a traditional IRA.

· The younger the IRA account holder’s age, the more the benefit. This really comes down to two principles: 1) There will be less in the IRA because of the younger age, so there will be less taxes incurred at the time of conversion; and 2) The owner will have more time to plan his or her retirement, thus avoiding the need for distributions, giving the Roth IRA more time to grow, taking advantage of compounding interest.

· State taxes. If, at the time of conversion, you live in a state with no income taxes, but you anticipate your retirement home in a state with income taxes, then a conversion could lessen your potential tax burden by avoiding state income taxes by accelerating the tax due.

Disadvantages of Current Conversion

· Tax rates may not increase. The main benefit of a conversion is you are locking in the current 35% maximum tax rate on income, opposed to the projected 39.6% (or higher) maximum rate in future years. If you expect your income to fall in your retirement years when you are actually drawing from the IRA, then you may qualify for a lower tax bracket, making this tax hedge a needless expense.

· You accelerate the tax due to the current year. Even though this is “rollover” you are switching the account from a before-tax account to an after-tax account, so the total value will have to be included in your taxable income. The best way to benefit from this rollover is to pay the taxes from non-IRA assets. If you do not have sufficient assets to pay the necessary taxes, then this conversion is not recommended for you as the amount which could grow tax-free will be lessened.

· You could incur penalties. If the rollover occurs before the IRA owner is 59 ½ years old, then any amount not rolled-over (i.e., amounts used to pay the taxes incurred) will be subject to an additional 10% penalty tax for early withdrawal. Also, all amounts contributed must remain in the account for 5 years. If amounts are withdrawn before the 5 year mark, regardless of whether the owner is retirement age, they will incur a 10% tax penalty. If you foresee either of these applying to you, a conversion is probably not a good idea.

· State taxes. If, at the time of conversion, you live in a state with income taxes, the converted amount will be taxed at the state level. If you plan on retiring to a state without income taxes, like Florida, then you will have needlessly paid income taxes to your current state.

Is Conversion Right for Me?

Although this article cannot specifically address every situation for every person, it is written to address the two main benefits of a conversion from a traditional IRA to a Roth IRA; hedging income tax rates and no RMDs. The current tax rates are the lowest they have been in recent history and they are likely going to be lower than tax rates in the foreseeable future given the current political alignment in Washington. Even if tax rates are not raised through specific legislation, the current maximum rate of 35% will revert back to 39.6% in 2011when the Bush tax cuts expire. If a taxpayer currently is in the highest income tax bracket, and foresees staying in the highest bracket throughout retirement, then this hedge would probably be beneficial for him, strictly speaking to saving taxes. Secondly, if the taxpayer is in the highest marginal income tax bracket he probably will not need the RMDs as required by a traditional IRA, so by converting to a Roth IRA, the taxpayer can continue to grow the account tax-free until it passes to his or her beneficiaries at death. This tax-free growth could result in significantly more value over a taxable RMD and a subsequent investment of the distributed amount.

If these two characteristics apply to you, then a conversion of your traditional IRA should be reviewed more fully with your tax professional.