In 2010, anyone with a traditional IRA, including a rollover IRA, will have the opportunity to convert that IRA into a Roth IRA regardless of income. Previously, only individuals with a modified gross income of greater than $100,000 were unable to do a Roth conversion. Effective in 2010, that restriction is removed and all individuals are able to convert an existing traditional IRA into a Roth IRA. At the time of conversion, income tax is due on the amount moved into a Roth IRA. In evaluating whether the Roth benefit of tax-free income growth is worth the acceleration of the income tax due on the assets converted, many factors should be considered including current tax situation, estate consideration and prediction of future tax rates.
A Roth IRA differs from a traditional IRA in that the contributions to the account have already been subject to income tax. The earnings from a Roth IRA are not subject to income tax at the time of distribution if it is a “qualified distribution”. A distribution is qualified if: 1) the distribution is made after the five-tax year period that begins with the first tax year the taxpayer made a contribution to a Roth IRA, and; 2) the account owner is 59 ½ years old when the distribution is made or the distribution is due to death, disability or the purchase of the a home by a qualified first-time homebuyer ($10,000 maximum). Another significant difference between traditional and Roth IRAs is that Roth IRAs are not subject to the minimum required distribution (MRD) rules during the IRA owner’s lifetime, thus allowing a longer period of tax-free growth.
A major factor in deciding whether to convert to a Roth IRA is the ability to pay the income tax due from assets outside the IRA funds. While the taxes due as a result of this conversion in 2010 can be paid in 2011 and 2012, this still may be a sizeable tax bill. Without sufficient alternative funds, an individual may find that there is a significant decrease in the total assets in the Roth IRA after using some funds to pay the income tax. Additionally, if the IRA owner is under age 59 1/2, there would be a 10 percent penalty tax for an early distribution on the funds used to pay the tax. Individuals should consider the impact of future tax rates. Currently the income tax rates are 25 percent, 28 percent, 33 percent and 35 percent. However, in the absence of any Congressional action, the income tax rates will revert to the pre-2001 levels of 28 percent, 31 percent, 36 percent and 39.6 percent in 2011. As a result, individuals may wish to consider paying the income tax due from the conversion in 2010 and not utilize the option to defer the tax into 2011 and 2012. A complicating factor in making this decision is the possibility that the amount of the conversion could move the tax-payer into a higher bracket.