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Changes in Roth IRA Conversion Rules

The rules for converting an employer-sponsored qualified plan account or traditional IRA to a Roth IRA will change significantly on January 1, 2010. As a result, more investors will be eligible to convert and the tax liability triggered by a 2010 conversion will be deferrable. Particularly once the changes take effect, a Roth IRA conversion deserves serious consideration.

How a Roth IRA Works

Unlike other IRA varieties, a Roth IRA does not offer a current-year tax deduction on contributions. However, the earnings on your Roth IRA investments will never be taxed, not even upon withdrawal, provided certain conditions are met. Generally, those conditions require you to hold your Roth account at least five years and through age 59½. In addition, a Roth IRA does not require minimum distributions after age 70½, as is the case with most retirement plans.

What a Conversion Entails

Federal law allows you to convert a traditional, rollover, SEP, SIMPLE or SAR-SEP IRA to a Roth IRA. Also, amounts in an employer-sponsored qualified pension, profit-sharing or stock-bonus plan, such as a 401(k) or 403(b); an annuity plan; or a government-deferred compensation plan, such as a 457, generally qualify for a Roth IRA conversion. However, because only after-tax money can be kept in a Roth IRA, any deductible (pre-tax) contributions you made to the old account, plus earnings on either deductible or nondeductible contributions, will be taxable upon the conversion.

What’s Changing

Starting in 2010, anyone, regardless of income or filing status, will be eligible to do a Roth IRA conversion. Currently, you qualify only if your modified adjusted gross income (MAGI) is $100,000 or less and your tax status is something other than married filing separately. (MAGI is calculated as your total income minus certain deductions.)

Also, you will be able to defer the taxes on a 2010 conversion over the subsequent two years. You will have the opportunity to defer half the income until 2011 and the other half until 2012. This tax deferral provision will apply only to 2010 conversions.     

Would a Conversion Make Sense in Your Case?

Making an informed decision on whether to do a Roth IRA conversion requires a detailed analysis of your personal circumstances. There are several key factors to consider. Start with these questions:

·         What’s your tax outlook? Generally, a conversion works in your favor if you can reasonably project that the current-year taxes triggered by your action would be less than you would pay later if you were not to do a conversion. In other words, if you think you’ll be in a higher tax bracket during retirement or anticipate higher tax rates by then, then doing a Roth conversion – and getting the tax liability out of the way now – might be a smart move. On the other hand, if you expect to be in a lower tax bracket during retirement than you’re in now, the advantages of a conversion may be less substantial – but you should still give some thought to a conversion.

·         Would a conversion push you into a higher tax bracket? The amount you convert will be taxed as additional income. If this would bump you into a higher tax bracket, you could choose to convert no more than the maximum amount that would allow you to stay in your current bracket. You could also convert over multiple years.

·         Can you afford it? To pay the taxes triggered by conversion, you do have the option of using funds from the qualified plan or traditional IRA assets being converted. But typically, this is not a good idea if you’re under age 59½, because you will generally incur a 10% early-withdrawal penalty on the amount you take out of the funds being converted – plus, you will be left with less money to fund your Roth IRA. Generally, therefore, a conversion is worthwhile only if you can afford to pay the taxes due from a source of cash other than the very assets being converted.

·         How long might you hold the Roth IRA before starting to withdraw funds? The longer you go without tapping the Roth account, the longer you will be able to take advantage of the potentially tax-free accumulation of earnings. If you are 10 or more years away from needing to draw funds from the account, give serious consideration to converting; if you’re closer to taking withdrawals, a conversion generally makes less sense. Withdrawing funds within five years of conversion may expose you to a 10% early-withdrawal penalty if you’re under age 59½.

Although there’s no easy answer as to whether you’re a good candidate for a Roth IRA conversion, having a personalized financial plan in place makes the decision easier. After all, once you have a plan, you’ve already considered how various factors can influence your future and you may have modeled different “what-if” scenarios. At Grand Wealth Management we help our clients make smart decisions about their money by preparing tailored financial plans and analyzing decisions such as whether a Roth IRA would be beneficial.

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