ROTH IRA Conversions

A traditional individual retirement account (IRA) is funded with before-tax contributions and grows tax-deferred, but not tax-free. (Taxpayers with a 401(k) plan provided by their employers, and who fall into higher income tax brackets, generally cannot deduct an IRA contribution.) Beginning at age 70-1/2, the individual must take minimum distributions from a traditional IRA, which are taxed in full at the income rate then applicable to the taxpayer.

By contrast, contributions are made to a Roth IRA with after-tax money. If the account has been held for at least five years, the accumulated principal and interest in a Roth IRA may be withdrawn tax-free once the individual reaches 59-1/2. Unlike a traditional IRA, there are no mandatory minimum distributions for a Roth IRA.

The ability to make contributions to a Roth IRA is phased out for couples with a modified adjusted gross income of between $150,000 and $160,000 ($95,000 to $110,000 for individuals). While those contribution restrictions will remain in place, a new law that goes into effect in 2010 will open up the Roth IRA to higher-income taxpayers by allowing them to convert a traditional IRA account into a Roth IRA account, thereby benefiting from the Roth features when money is withdrawn. A current provision limiting Roth conversions to those taxpayers with adjusted gross incomes of under $100,000 will no longer be in effect.

When a conversion occurs, the individual withdraws funds from the traditional IRA account, reports those funds as income, and transfers them to a Roth IRA. The conversion must be done before December 31 of the current tax year. If the earlier IRA contributions were taken as deductions, taxes will be due on both the principal and the earnings. Otherwise, taxes will be due only on the earnings. In any event, funds can be converted from a traditional IRA to a Roth IRA without incurring the 10% penalty for early withdrawals.

Why worry now about a law that will not go into effect until 2010? Because proper planning and saving in a traditional IRA between now and then can result in a significant nest egg that can be converted into a Roth IRA when the income restrictions are lifted in 2010. For example, given current and projected limits on contributions to a traditional IRA, a married couple in their fifties, with at least one spouse working, could contribute over $50,000 to a traditional IRA over the next few years, then convert those funds to a Roth IRA, and thereafter reap the benefits of that type of retirement fund. Since some taxes will be due whenever the conversion takes place, it also is advisable to save up some funds outside of the account for that day of reckoning with the IRS.

A tax professional can help you determine whether and when to convert a traditional IRA into a Roth IRA, considering factors such as your current and future tax brackets and income, when you want to begin making withdrawals, and your estate plans in general.

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