We are rapidly approaching the fifth month of 2010. This year is notable for many things, and one of those is that this year it is possible for anyone — no matter his or her income — to convert a traditional IRA to a Roth IRA. There are some advantages to having a Roth IRA, one of those being that when it comes time to withdraw funds, you can do so tax free. Earnings in a Roth IRA grow tax free (but the contributions you make to a Roth IRA are after-tax to make up for this).
While the future tax implications might be tempting, especially if you believe you will be in a higher tax bracket. However, it is also important to consider the tax implications that come now. Here are some of the things to keep in mind with regard to taxes when you make a Roth IRA conversion:
- Your rollover to a Roth IRA is like a distribution: The money contributed to a traditional IRA came out pre-tax, lowering your taxable income. When you convert, the process is treated like a distribution from your traditional IRA, meaning that you have to pay income taxes on that money. Therefore, your Roth conversion will increase your tax bill. You can spread your tax hit over your 2011 and 2012 returns to reduce the initial impact, but the tax hit is still there.
- You could end up in a higher bracket now: Because the distribution from your traditional IRA for rollover into a Roth is treated as income, it might actually put you in a higher tax bracket for 2010, depending on how much you convert, and how close you are to the next tax bracket.
- Higher AGI = fewer deductions and credits in some cases: There are some tax deductions that you get as a percentage of your adjusted gross income (AGI), and some deductions and credits that phase out when you reach a certain income level. The increased income due to your Roth IRA conversion might actually put you over the limit in some cases, putting you on track to phase out. One example relates to those who are used to deducting medical expenses. If your expenses are at least 7.5% of AGI, you can deduct them. However, if your AGI increases, it may mean that your expenses may no longer account for 7.5%, and you become ineligible for the deduction.
A Roth conversion is not so simple isn’t it?
Just like any financial decision, what you decide to do about your retirement and the Roth IRA conversion is a very personal choice. However, many people have a knee-jerk reaction that conversion is desirable in all circumstances. There might be some cases in which the realities of Roth IRA conversion actually make it undesirable. Before you decide on a Roth IRA conversion, consider your financial situation, and consult with a tax professional who can help you work out the implications. Only after you have studied various scenarios and analyzed the numbers should you make a decision about the advisability of a Roth IRA conversion in your financial case.
So I must ask you. Are you planning to make the switch, or have you even thought about it yet?
- E*TRADE IRA - Official Site