In planning for retirement, choosing appropriate investments is an important consideration. But equally significant is choosing the most appropriate retirement vehicle.
As a result of a tax law change that took effect this year, there are no longer income limitations for a conversion to a Roth IRA. Thus, wealthy taxpayers who may have been shut out of Roth IRAs in the past have new opportunities to convert some or all of their traditional retirement accounts into Roth IRAs, says Steven Y. Patler, JD, CPA, a senior manager at Cendrowski Selecky PC.
“One thing is certain about Roth IRAs: the conversion decision is complex and very taxpayer specific,” says Patler.
Smart Business spoke with Patler about what to consider when deciding whether a Roth IRA conversion makes economic sense for your situation.
How is a Roth IRA different from a traditional IRA?
The most significant difference is that all distributions from a Roth IRA can be income tax free if certain requirements are met, such as age and holding period. On the other hand, there is no tax deduction for contributing to a Roth IRA.
Also, unlike traditional IRAs, there are no minimum required distributions during one’s lifetime. Eligibility for making contributions to a Roth IRA also differs.
How is a Roth IRA funded?
Basically there are two methods to fund a Roth IRA, annual nondeductible contributions and qualified rollover contributions, also known as conversion. Currently, annual contributions are limited to a maximum of $5,000 — $6,000 for those ages 50 and older — per year, and contributions made during the year to other IRAs may reduce this amount.
There are also income limitations for annual contributions, and no annual contributions can be made if a married couple’s modified adjusted gross income exceeds $177,000 ($120,000 for single) in 2010.
By far the biggest opportunity to fund a Roth IRA is through conversion. Unlike annual contributions, there are no income limitations for Roth IRA conversions starting in 2010, and any individual can convert a traditional IRA, SEP IRA, Simple IRA and eligible qualified retirement plan rollovers (including 401(k), etc.) to a Roth IRA.
Is there a cost to convert to a Roth IRA?
Yes. All amounts converted to a Roth IRA, except for after-tax contributions, are treated as taxable income and subject to tax on the individual’s tax return. After-tax contributions are those contributions made to an IRA or retirement plan in which the taxpayer did not obtain a deduction.
Paying tax on a Roth conversion is inherently contrary to most people’s thought process of paying less tax now. Although this is by far the biggest obstacle, the effects may be mitigated with proper planning.