In 2010 it may pay to convert to a Roth

THE MINNESOTA INVESTOR

GENE WALDEN

Two impending developments in the tax world could make 2010 an ideal time to convert your traditional IRA to a Roth IRA.

A change in Roth regulations will allow all families regardless of their income to convert their traditional IRA to a Roth beginning in 2010. Currently, the income limit for families who want to convert to a Roth is $100,000, which leaves many working couples well above the income limit.

The other anticipated change that would make conversion an attractive option next year is the projected increase in taxes for families with incomes of more than $250,000 in 2011.

The advantage of a Roth over a traditional IRA is that withdrawals from a traditional IRA are taxable at your current income level, whereas withdrawals from a Roth are tax free. The other advantage is that with a traditional IRA, you are required to begin taking withdrawals at age 70 1/2, whereas with a Roth, there is no time limit on when you have to start withdrawing your funds.

In fact, if you choose not to withdraw all your funds from a Roth during your lifetime, the account passes on to your heirs, who may withdraw the funds income-tax free (although the money may still be subject to estate tax).

"This gives you more flexibility in retirement to use the money when you need it," explains John Soukup, president of Bloomington-based Superior Wealth Management.

But there are drawbacks to converting a traditional IRA to a Roth. You are required to pay income taxes at your current income tax rate on all money you convert to a Roth, and you must pay the taxes with your existing savings since you can't use your IRA money to pay the taxes.

"Converting to a Roth does require planning," says Soukup. "Since you can't use IRA money to pay the taxes, you have to have adequate savings to pay the taxes."

The other requirement is that you must hold onto the Roth for at least five years after the conversion before you can start withdrawing money that is earned in the Roth. You can, however, withdraw the original amount with no taxes or penalties if you're over 59 1/2.

For instance, if you convert $100,000 to a Roth and that money earns $10,000 for a total of $110,000, you can withdraw the original $100,000 tax-free, but you have to pay taxes on the $10,000 earned in the account. Once the five years have passed, you could withdraw all of your money -- the original amount and any money earned through your investments -- without paying taxes or penalties.

Conversion strategies

When should you make the conversion? "If you're investing in stocks and you expect the market to go up, you should convert as soon as possible -- like January 2010," said Soukup. Otherwise, you'll have to pay taxes on all of your gains when you do convert to a Roth. But once your money is in a Roth, all the gains can be withdrawn tax-free.

"If you have enough time before you need the money to let the investment build up," he adds, "you should convert as much as possible to a Roth because your tax savings on the gains is so big."

What if you simply can't afford to pay the taxes to convert your entire IRA to a Roth? "It doesn't have to be all or nothing," says Soukup. "You don't have to convert it all at once." You can spread the conversion over two or three years to make it easier to pay the taxes, although if you don't convert before 2011, you will probably be taxed at a higher rate.

"You could convert it and pay it all in 2010 or you can clear some in 2011 and more in 2012," said Soukup, but you probably would be paying a higher tax rate those years.

Not everyone would benefit by converting to a Roth. If you're currently in a high tax bracket but anticipate moving to a low tax bracket after you retire, you could pay more in taxes to convert now than you would to take withdrawals from your traditional IRA after retirement.

But if you're not sure how your current and future tax rates will compare, and you can afford to pay the taxes for a conversion now, the flexibility the Roth will offer -- no income taxes for withdrawals, no deadline on withdrawing the funds, and the ability to pass the money on to your heirs tax-free -- could make 2010 the perfect time to convert to a Roth IRA.

Gene Walden lives in the Twin Cities and is the author of more than 20 books about business and investing. Send questions to gwalden100@comcast.net.