2010 Roth IRA Contribution Limits and Conversion Rules From Traditional IRA Retirement Accounts

Next year, all taxpayers – even those making more than $100,000 a year in adjusted income – will be allowed to convert to Roth IRA accounts from traditional IRAs. That means that more than 15 million Americans, can consider whether they want to make tax-deductible contributions if they have a traditional IRA or pay the taxes up front and have tax- free withdrawals during retirement with a Roth IRA. Which is better depends on future tax rates and how much the conversion will cost. It may not make sense to pay taxes today at a higher rate because many investors will be in a lower tax bracket during retirement, according to Tom Orecchio in a recent Bloomberg interview of various tax and financial planners, a fee- only adviser at Modera Wealth Management. “From a tax perspective, I think when people do the math, it’s not going to be as game changing as they expect it to be,” Orecchio said.

For example, a taxpayer in the 28 percent federal tax bracket who shifts $100,000 of pretax dollars to a Roth IRA from a traditional IRA would pay $28,000 in taxes, in addition to whatever is owed in state taxes. “There are many people who simply don’t have that kind of a side account to pay the income tax, so for them it isn’t very practical to consider a Roth,” said Christine Fahlund, a senior financial planner at T. Rowe Price Group Inc. in Baltimore.

A partial conversion to a Roth IRA from a traditional IRA may be the most tax-efficient plan because of the diversification benefits, said Orecchio, who estimates about half of his clients may convert some money to a Roth IRA next year. “You never know how the tax code will work in the future. By owning different IRAs, you’re protected from whatever the government might decide to do,” Orecchio said.

Partial conversions may also be desirable for those with larger portfolios that would require a large tax payment at conversion, said Fahlund of T. Rowe Price. And the flexibility of partial conversions can also be beneficial to those who are self- employed or whose income varies year to year. In a year with less income, an investor can convert less of a traditional IRA to avoid having a larger tax burden for the year, according to Fahlund.

Holding Period
The Roth accounts, including those converted from traditional IRAs, must be held for five years and account holders must be at least 59 and a half before money can be withdrawn tax free. Savers who don’t follow the withdrawal rules or meet exemptions face a 10 percent penalty for distributions. Investors who decide to convert to Roth IRAs must declare the conversion amount on their tax forms. The tax owed depends on whether the assets being transferred are made up of pre or post-tax dollars. In 2010 only, converters will be able to pay the tax liability in 2011 and 2012.

There’s a fallback for investors who decide to convert and regret the decision. A Roth can be switched back to a traditional IRA account, or re characterized. Since investors who convert to a Roth IRA don’t have to pay taxes on the conversion until the following year, they have until April 2011, or October 2011, if they get an extension to file, to reverse the conversion, said Slott, the IRA consultant.

[2010 Update] Vanguard recently published some good factors to consider when considering converting an IRA to a Roth IRA. These include:

1. You have to pay taxes on the amount you convert. In return for the potential future tax breaks of a Roth, you have to pay income taxes when you convert. That means if you have money in a traditional IRA that you haven’t yet paid taxes on, you could have a substantial tax bill. Say you’re in the 28% tax bracket, you could owe $28,000 on a conversion of $100,000. Still, converting may benefit you in the long run if you expect you’ll be taxed at a higher rate when you retire. If you expect your rate will be lower, converting may not be beneficial. If, like most people, you’re not sure what your future tax rate may be, you could consider converting just part of your traditional IRA to a Roth. Doing so gives you “tax diversification” because you’ve got some money in a Roth and some still in a traditional IRA.

2. It’s a good idea to use money outside of your IRA to pay the conversion taxes. You can get the most benefit from switching to a Roth if you can pay the conversion taxes without using money from your IRA. If you convert and don’t pull money out of your IRA, you can increase your after-tax purchasing power in retirement. In effect, $10,000 in a Roth IRA gives you more to spend in retirement than $10,000 in a traditional pre-tax IRA. Remember, taxes could substantially reduce the amount you’re left with when you withdraw from the traditional IRA.

And there’s another reason not to tap your IRA for the conversion taxes: If you’re under age 59½, the amount you withdraw may be subject to a 10% IRS penalty. A cash account may be a good place to get the money to pay the taxes on the conversion.

3. You can lighten the tax burden of a conversion. If you don’t have enough money to pay taxes on converting all your traditional IRA assets, or if doing so would push you into a higher tax bracket, you can consider converting just part of your assets. In addition, a special provision applies to 2010 conversions that gives you the option of postponing the tax bill and paying it off over two years. If you choose this route, taxable income that results from the conversion gets split evenly between 2011 and 2012. But be aware that tax rates are scheduled to go up in 2011, so—barring any new tax legislation—you could end up paying taxes at a higher rate.

4. Penalties may apply if you withdraw within five years of a conversion. A conversion may not be for you if you expect you’ll withdraw the money within five years. Generally speaking, you’ll only be able to withdraw earnings from the account without taxes and penalties if you’re age 59½ or older and you’ve held the Roth IRA for at least five years.As for withdrawals of your original conversion amount, those are tax-free. But to avoid a 10% IRS penalty, you generally must be either at least age 59½ or wait at least five years after your conversion to make the withdrawal.

5. Your heirs may benefit from the conversion. During your lifetime, you don’t have to take money out of the Roth IRA because you’re not subject to RMDs. That means you can leave the entire accumulated balance to someone else. And while a beneficiary who inherits your Roth IRA may be subject to RMDs, he or she can withdraw the amount of your original conversion tax-free. Any earnings are also tax-free, provided that the Roth IRA meets the five-year holding requirement.

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