Since they have been available to investors starting in 1997, Roth IRAs have provided the unique ability to put away after-tax dollars in a retirement account and to withdraw those funds and their market gains tax-free during retirement. Investors lose the tax write-off of contribution to a traditional IRA, but the gain the ability to withdraw money without any tax obligations later in life instead of just putting off taxes until the money is withdrawn. Roth IRAs have grown in popularity as investors have become more educated about their advantages.
One of the limitations of Roth IRAs has always been an income limit that eliminated some individuals from contributing to a Roth IRA. Next year, for the first time, investors will be able to convert their traditional IRAs to Roth IRAs regardless of the income they report to the IRS. However, the converted amount will be taxable as income and could increase an investor’s tax liability for at least a couple of years. Here are some of the considerations you should take into account as you decide whether or not to convert.
– Taxes: The biggest impact in the short term of converting will be taxes. However, the IRS has provided some flexibility for taxpayers to at least spread the tax burden over a couple of years. Those converting can choose to pay the income tax due on their 2010 taxes or to split the amount due between 2011 and 2012. The risk here is that many experts agree that taxes are going up to cover the shortfalls in the national budget and if taxes increase in the next few years, the taxes paid on the converted amount could be at a higher marginal tax rate. The other decision to make around taxes is whether you’d rather bite the bullet and pay taxes now or save the pain of taxes until later. There are several online resources and calculators to help investors see the impact of their decision.
– Timing: As of now, this option will be available for all of 2010, but what is the best time to convert? The answer is that it’s best to convert early in the year. The tax code provides a loophole called “recharicaterization” that allows an individual that converted to a Roth to change their mind and go back to a traditional IRA if they change their mind about the strategy before filing for their 2010 taxes. Essentially, if you convert on the first day of 2010, you have well over a year to determine if it was the right decision to make.
– Expert Advice: Ask your accountant and financial advisor what they would recommend for your situation. A Roth conversion is a great option for many people, but not for everyone. Factors such as your state of residence during retirement and the amount of income you’ll need to live on from your IRA during retirement can have an impact on your decision. Start having these conversations now so that you have time to make the decision that’s right for you.
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