2010 Roth IRA Conversion

Do not miss out on an unprecedented retirement and estate planning opportunity.  During 2010, converting “traditional” IRA accounts into “Roth” IRA accounts present some unique opportunities.

TRADITIONAL vs. ROTH

A traditional IRA is an individually-owned retirement account in which the owner can receive a tax deduction upon the contribution of assets (maximum of $5,000 for 2010) to the account.  The assets in a traditional IRA grow tax free.  Upon withdrawal of assets during retirement, the owner pays ordinary income tax.  In contrast, a Roth IRA is an individually-owned retirement account in which the owner does not receive a tax deduction for contributions.  Instead, in general, the withdrawals from the Roth IRA, including asset appreciation and growth, are not subject to income tax.

THE 2010 CONVERSION OPPORTUNITY

Owners of traditional IRAs can convert their accounts into Roth IRAs if the owner pays income tax on the value of the converted assets.  During 2009, income limits were imposed on which taxpayers could convert from a traditional to a Roth IRA.  In 2010, however, there are no income limitations.  An additional benefit to converting in 2010 is the ability for a taxpayer to split the income tax liability between two years.  In sum, a taxpayer who converts in 2010 can pay one-half of the income tax liability in 2011 and the other half in 2012.

Two factors should be considered in deciding whether or not to convert.  First, asset values in your traditional IRA may still be low, resulting in a lower income tax liability than in previous years.  Additionally, several analysts expect income tax rates to increase, raising the top marginal income tax rate.  For taxpayers at or near the highest marginal tax bracket, it would be better to pay income taxes now (at 35%) instead of later (at 39.6% in 2011 and at 43.4% in 2012).

RETIREMENT BENEFITS OF CONVERTING

In retirement, a Roth IRA provides more flexibility than a traditional IRA in taking distributions.  Upon reaching age 70.5, a traditional IRA owner must take required minimum distributions every year and pay income tax on the withdrawn amounts.  Consequently, you may be forced to take distributions even if they are not desired or necessary to maintain a certain standard of living.  Conversely, a Roth IRA owner has more flexibility in making withdrawals.  A Roth owner can withdrawal as little (or as much) as his/her budget requires.  The remaining portion of the Roth account continues to appreciate free of income tax.

For IRA owners who have many work years remaining, converting to a Roth IRA could yield tremendous income tax savings.  Even for IRA owners closer to retirement, converting from a traditional IRA to a Roth IRA may make sense.

ESTATE PLANNING BENEFITS OF CONVERTING

Traditional IRAs are less attractive wealth transfer vehicles.  The beneficiaries of a traditional IRA must pay income taxes upon the receipt of distributions from the inherited traditional IRA.  Consequently, only a portion of a traditional IRA’s value is received by beneficiaries with Uncle Sam receiving his share in the form of income taxes.  Additionally, if a taxpayer dies with an estate exceeding the estate tax exemption amounts, the estate will pay estate taxes on the total value of the traditional IRA, including the portion that Uncle Sam will receive as income tax.  The beneficiaries of a traditional IRA may be entitled to an income tax deduction of the estate taxes paid on the account.  Regardless, the beneficiaries of a traditional IRA will not receive the full value of the account due to estate and income taxes.

Conversely, a Roth IRA, even though subject to estate taxes, does not subject the beneficiaries to income tax on the withdrawals.  Therefore, a Roth IRA is a more tax-efficient wealth transfer vehicle.

This year presents a unique opportunity but time is running out.