ROTH IRA: Why Convert

It’s a given that unlike the traditional Individual Retirement Fund (IRA), contributions to a ROTH IRA are not tax-deductible. In addition, despite the fact that you cannot have a tax-free withdrawal from your principal – unless the account has been existing for 5 years and that tax is applied for earnings withdrawn before reaching the age 59 ½ – there are fewer withdrawal requirements on ROTH IRA over a traditional IRA.

But how valuable is it to convert to a ROTH IRA now?

Specific advantages:

• Perhaps the recent heavy stock market losses wore down the value of your traditional IRA. This should alert you that the federal income tax on your future withdrawals could further erode your nest egg. Therefore, since conversion from a traditional IRA to a ROTH IRA generates a tax bill, but only on the year of conversion after which the new ROTH IRA balance can be withdrawn tax-free (subject to the 2 above-mentioned stipulations), today could be a golden opportunity to reduce your tax bill by paying taxes corresponding to smaller amount.

• This also means that you can choose to settle your tax obligations upfront, while tax rates are lower, and deal with tolerable restrictions in the future. With a deductible IRA for example, you can only start your principal withdrawals after reaching the age 70 ½. In contrast, you only need to wait for 5 years (also known as the “seasoning period”) after converting to ROTH IRA before you can start federal income tax free principal withdrawals.

• If conversion to Roth IRA will prove to be ill-advised, a grace period is provided for you to reverse your decision. From the date of conversion, you have until October 15 of the following year to re-characterize your converted account back into its traditional IRA status without owing any federal income tax (applicable to year it was converted) to the newly-re-characterized conversion.

Income requirements for conversion: Current & 2010

Current requirements state that taxpayers must have a Modified Adjusted Gross Income (MAGI) of less than $100,000 for both single and married filing in order to take advantage of the ROTH IRA conversion. The good news is, taxpayers who have always wanted to convert but could not qualify based on the incomelLimit requirements may start converting in 2010, when this restriction is lifted.

Moreover, under the new 2010 IRS rule (which is applicable to 2010 only), if you convert a traditional IRA into Roth IRA, you may distribute the converted amount to 2011 and 2012, which gives you the option not to pay any taxes in 2010 on the amount converted.

Before your final decision…

All these advantages being laid out, every taxpayer has specific needs and standards on or before retirement, and owing to the complex relationship among a person’s income, lifestyle status and the host of IRA options in the market, it is always best to consult a tax professional before converting an existing retirement account. This ensures a better grasp of how the ever-changing tax rules would affect you.