Note to Reporters: Vickie Bajtelsmit is a finance professor in the Colorado State University College of Business and the author of three personal finance books.
Under current tax rules, households with income greater than $100,000 cannot convert traditional Individual Retirement Accounts (IRAs) to Roth IRAs. However, as part of the 2006 Bush tax cuts, this income limit will be removed in 2010. So it’s a great time to consider whether this retirement saving strategy is right for you.
To understand why you might want to convert your traditional IRA, you may first need a brief primer on IRAs. Although both traditional and Roth IRAs are designed to encourage you to save for retirement by giving you a tax break, they do so in very different ways.
Contributions to a traditional IRA are tax-deductible whereas Roth IRAs are funded with after-tax income. The contribution limit for either type is $5,000 for 2009 ($6,000 for taxpayers age 50 and over). If you’re in the 25% tax bracket, the tax deductibility of the traditional type means that your actual cost of putting in the $5,000 is $3,750, because you’ll save $1,250 from the tax deduction.
Withdrawals from traditional IRAs are taxed at the time of withdrawal at whatever your tax rate is at the time. The big advantage of the Roth is that you can withdraw it tax-free. Essentially, a Roth gives you tax-free earnings forever.
Since taxes on contributions and investment earnings are due when you convert to a Roth, why would you ever want to do so? If you believe, as I do, that tax rates will rise in the future, it’s preferable to pay the lower tax rate now in return for not paying a higher rate when you withdraw the funds.
If you plan to retire early, you can take distributions from a Roth, up to the amount of your actual contributions, prior to age 59 ½ without taxes or penalties. In contrast, early withdrawals from a traditional IRA are subject to federal and state income tax as well as a 10 percent penalty.
You can also use up to $10,000 of your Roth toward a first time purchase of a home for yourself, your child, or grandchild. Another advantage of the Roth is that there is no requirement that you begin taking distributions by age 70 ½ as required for traditional IRAs. You could even leave the Roth to your heirs to enjoy tax-free distributions later on.
Taking all of these advantages into consideration, I still wouldn’t conclude that everyone should have a Roth. However, the younger you are, the lower your tax bracket right now, and the higher you expect your income in retirement to be, the more it probably makes sense.
If your income is too high to open a Roth or to convert your traditional IRA right now, think about converting in 2010. You may also be able to move old 401(k) accounts to IRAs and convert them as well.
Of course, you should consult with a financial advisor about any of these strategies. You will owe taxes on the converted assets, but this may be a great year to pay them, particularly if you have experienced investment losses. The tax rules allow you to either pay the taxes in 2010 or spread them out between tax years 2011 and 2012, so that might give you a little breathing room.
One caveat–even if you are able to convert to a Roth, you may not be able to add new contributions to this account in future years. Eligibility is phased out between $105,000 and $120,000 for singles ($166,000 and $176,000 for married). If you’re lucky enough to make too much money, you’ll have to make new contributions to a traditional deductible IRA.