By KATHLEEN PENDER
San Francisco Chronicle The biggest financial decision many people will make this year is whether to convert a regular individual retirement account into a Roth IRA.
Before this year, you could not make this conversion if your modified adjusted gross income was more than $100,000. But that income limitation was abolished in 2010, and now anyone can convert some or all of a traditional IRA into a Roth.
Making this conversion can save you money if your tax rate is lower now than it will be when you take money out of your IRA. If your tax rate is higher now than it will be then, it might be better to leave your regular IRA alone.Unfortunately, knowing what your tax rate will be in the future is impossible. It depends on your income in retirement and what Congress does with tax rates.
The best you can do is make an educated guess.
If you decide to convert, there are good reasons for doing it in 2010 and for doing it earlier in the year rather than later.
If you change your mind, you can reverse the conversion for any reason as late as October 2011. "There is a wonderful undo button," says Sandi Bragar, a wealth manager with Aspiriant.
When you put money in a regular deductible IRA, you subtract it from your income that year and it's not taxed. As the account grows, you pay no tax on your earnings. But when you withdraw money, it is added to your income for that year and taxed at the same rate as your ordinary income.
With a Roth IRA, contributions are not tax-deductible. But your earnings grow tax-free and usually remain tax-free when you take them out. But if you take money out within five years of the conversion and are not yet 59-1/2 years old, you probably will owe a 10 percent penalty.
It's simple: With a Roth you pay taxes now, and with a regular IRA you pay them later. The goal is to pay them when your tax rate is lowest.
The law allows you to convert a regular IRA into a Roth IRA, but the sum converted is added to your income for that year and taxed. Coming up with the cash to pay this tax discourages many people from making large conversions.
You should strongly consider converting if:- You are young, and your tax rate and IRA balance are low.
- You are unemployed, so your tax rate is temporarily low, and you can afford to pay the tax.
- You think your tax rate will be higher in retirement because your income will go up or Congress will raise tax rates or both.
- You won't need your IRA before you die. When you turn 70-1/2, you must take money out of your regular IRA each year and pay tax on it. Roth IRAs do not require this minimum distribution.
"Once you take the tax hit, you never have to withdraw in your lifetime and it can just build" tax-free for your heirs, says IRA expert Ed Slott.
Your heirs will have to take distributions spread over their lifetime, but they will usually be income-tax-free. With a regular IRA, heirs also must take distributions, and they're taxable.
Who should not convert?
You probably should not convert if you:
- Think your tax rate will be lower when you retire.
- Don't have enough cash outside your IRA to pay tax on the conversion. If you take extra money out of your IRA to pay it, you will owe federal and state income tax on it and -- if you're not yet 59-1/2 -- a 10 percent penalty in most cases.
- You need the money within five years. If you take it out within five years and you are not at least 59-1/2, you will probably owe the 10 percent penalty, so it's not worth the hassle of converting.
- You plan to leave your IRA to charity.
What if you're unsure?
If you're not sure what to do, consider putting some money in a Roth and leaving some in a regular IRA or 401(k) plan to give you more tax flexibility.
If you convert in 2010 only, you have a choice of when to pay the tax. You can include 100 percent of the amount converted in your 2010 income, or you can put half in 2011 and half in 2012.
