Even high income earners are eligible to make a Roth IRA conversion starting in 2010. To sweeten the deal even more, those who elect to make the transfer can spread out the taxes owed in years 2010 and 2011. But how does the roth IRA conversion work? What are the consequences?
Consider This Before Making the Conversion
Before you start to converting a your IRA to Roth, you must make sure that such a conversion is advantageous. It sounds obvious, but it’s easier said than done.
Traditional IRA withdrawals are subject to taxation, while Roth IRA withdrawals are tax free. So if you take funds from a traditional IRA, you have to pay taxes on what now is considered taxable income before you can make a contribution to a Roth IRA. Even if you decide it is worthwhile to pay taxes on a traditional IRA withdrawal, you need to make sure you have extra cash available to cover your tax debt. This is important. If you have to take money out of a IRA account to pay for taxes, you pretty much take away any advantages you have in converting, as withdrawing money from your traditional IRA account before you are 59 and a half years old or older comes with a hefty 10 percent penalty.
The general advice is to figure out whether you will be in a higher tax bracket when you take contributions to determine if Roth IRA is a better choice, but I doubt that anyone will be paying less taxes in the future. My theory is based on the following:
- Inflation – Tax brackets are adjusted for inflation, but none (or at least not many) of the tax deductions are adjusted for inflation. By the time you retire, you may be paying very high taxes as if you are a high income earner even though the income only allows for a very modest lifestyle.
- Less Deductions – As you age, you (hopefully) won’t have mortgage deductions, nor will you be able to deduct for child support etc. Less deductions means higher taxes.
- Retirement Shelters – Many people try to figure out their gross income in retirement vs their income now when determining tax brackets, but a chunk of our income now funds our retirement accounts, which is tax free.
The way I see it, there are too many assumptions to make the decision objective. If you strip down all the hoopla, you are essentially contemplating a hit now against forever tax free withdrawals. Since the long term trajectory of account balances is up, the longer the IRA remains funded, the higher the chance that a Roth IRA will be more beneficial. Also note that Roth IRA inheritance is untaxed as well, so your kids will benefit from tax free growth for your decision today.
The Actual IRA Conversion
In the event that you decide to go ahead with a conversion, the transaction is simplified if you stay with the same trustee. All you have to do is rename the account as a Roth IRA. Of course, this is only in theory, so have a chat with the company where your account resides, as their rules might be different. For example, some institution may ask you to open a new Roth IRA account and simply transfer the assets over.
If you decide to seek a new trustee, you have the option of moving your funds yourself in a 60-day window without being subject to penalties. Moving the money in an exchange between trustees is less cumbersome, and highly recommended.
December 31st is the deadline for conversion if you want to be assessed in that tax year. If your income in the following year could put you in a lower tax bracket, conversion should be postponed. Also keep in mind that you can always transfer a small portion of your account every year to lessen the affect of an increased tax bill.
One Last Note
There are many variables in a conversion from a traditional IRA to a Roth IRA. I know they might seems expensive, but speaking with a competent tax professional is highly recommended before doing a conversion. The right move could literally save you millions in the long run.
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