Written by Sean Pollock

Thursday, 17 September 2009 04:48

Rules for Roth IRA conversion are about to change. In 2010, a new set of tax provisions kicks in. These new rules provide convenient options for restructuring your retirement plan’s arrangement. That is, regardless of your adjusted gross income you will be able to convert your traditional IRA into Roth IRA, and pay a one-time tax at the time of conversion. What does it really mean to you? Could you benefit from this change?

First, let’s look at the difference between traditional IRA and Roth IRA. Contributions are generally tax deductible for traditional IRA, and taxable for Roth. On the other hand, distributions from traditional IRA are taxable, while these from Roth are not. Both options allow capital to grow untaxed. Therefore, with retirement arrangements you pay taxes only once: either today (Roth option), or upon retirement (traditional option). Which option is better?

It is important to bear in mind that the both options are equivalent if your tax rate stays the same. Now, if you expect your tax rate to drop when you retire (because you expect your income to drop in retirement), you are better off with traditional IRA. This is the case for more senior people, who have already reached their peak salaries and do not expect promotions before retirement. On the other hand, if you expect your tax rate to increase, Roth would save you money. Therefore, these younger individuals, in the middle of their carriers, could anticipate higher salaries and therefore higher taxes in the future. Inflation is another important consideration. Even if you do not anticipate dramatic salary increases, they most likely will be adjusted for inflation, that is, these in their 30s will likely see their salaries double in dollar amount before they reach the retirement age. This will move them to a next, higher tax bracket.

There are other considerations that make conversion to Roth attractive. Because stock market has fallen more than 30% last year and is due for a long-term correction upwards chances are that your IRA’s face amount is close to its all-times low. Given that you will pay taxes on a face amount of your funds that are being converted, it could mean a considerably lower tax bill. Secondly, for 2010 only, you get an option to claim first 50% of the conversion amount as income in 2011 and another 50% in 2012.

Finally, the younger is the taxpayer, the higher is the chance that they will witness a federal tax increase. For example, if the Congress does not make Bush-era tax breaks permanent, income taxes will increase starting as early as 2011. Also, multiple financial experts have voiced the concern that due to increasing deficit federal taxes would become higher during this decade. Remember, higher income taxes during your retirement make it beneficial to pay a lower tax in 2010, through an IRA conversion.

All the above makes a great case to consider conversion very seriously, especially for these in their 40s and younger. Given that it is a big decision, and a significant money commitment, it is best to prepare to this move in advance.