This year, the federal government has loosened restrictions on converting a traditional IRA to a Roth IRA. Effective for calendar year end 2010, there are no income limitations preventing conversion; in the past, taxpayers with adjusted gross income exceeding $100,000 could not convert a regular IRA to a Roth IRA.
A Roth IRA is funded with after-tax income, and money that accumulates in the account is not taxed upon withdrawal. That can create a significant tax savings over time and it presents an opportunity to grow wealth over the long term.
Some 401(k) plans do not allow for Roth IRA rollovers from active participants; however, the rules have just been changed, and active participants are allowed to roll over their 401(k) accounts to Roth IRAs, and the employer’s 401(k) plan can be amended later.
“This opportunity is the one exception where we are advising some of our clients to ‘prepay’ the IRS,” says David Shaffer, a director at Kreischer Miller.
Smart Business spoke with Shaffer about what to consider before deciding whether to convert a traditional IRA to a Roth IRA.
What are the key advantages to converting a traditional IRA to a Roth IRA?
The primary advantage is the opportunity to realize tax-free growth on retirement savings. Also, Roth IRAs do not require the beneficiary to take distributions, whereas a traditional IRA requires that distributions be taken starting at age 70-and-a-half. This means that money in a Roth IRA can grow tax free for the donor’s life and grow tax free over the beneficiaries’ estimated life upon the donor’s death. For example, a 65-year-old person may convert $500,000 from a traditional IRA to a Roth IRA, pay the tax and watch the money grow tax free over their lifetime. At death, their beneficiary is required to take distributions, but they are calculated over the beneficiary’s estimated life, extending the tax-free benefit.
Other potential advantages are that you can elect to take the taxable conversion amount in income in 2010 or, if no election is made, equally over two years, in 2011 and 2012 tax returns; you can get a mulligan if investments don’t perform; the tax paid is now out of your estate; and because you don’t have to take the money out of a Roth, Social Security proceeds may not be taxable and certain investment income may not be subject to future surtaxes. We have run simulations where some taxpayers with $500,000 in retirement savings could potentially add $1 million or more to their family wealth by converting a traditional IRA to a Roth.
