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Roth Conversions: The Time is Prime

By: Investor Solutions

By: Investor Solutions

Every cloud has a silver lining. The unfortunate downturn in the market lately has many people concerned about whether or not they will be able to retire or whether they have to go back to work if already retired. Thats the black cloud. But here is the silver lining, because the value of accounts has decreased, it has never been a better time to convert a traditional IRA to a Roth IRA at a lower tax cost.

There are a number of reasons for converting from a traditional IRA to a Roth IRA. These include:

  • No Required Minimum Distributions (RMD)
  • By paying the tax now on IRA assets, you prepay the tax for your heirs who will inherit the IRA assets tax free upon your passing
  • The potential for paying less tax if you expect to be in a higher tax bracket when you will need to draw from the IRA assets
  • Qualified distributions from Roth IRAs are completely tax free and penalty free if the account owner is at least 59 ½ and the account was established at least five years ago

There are only two requirements for Roth conversion eligibility:

  1. 1 Your Modified Adjusted Gross Income (MAGI) for the year of the conversion is not in excess of $100,000
  2. 2 You are not a married individual filing a separate return

It is important to mention that the $100,000 MAGI limit does not include the Roth conversion amount. Therefore, you can withdraw all or a portion of your traditional IRA and reinvest it into a Roth IRA within 60 days. As long as you reinvest the full amount you withdrew from the traditional IRA into a Roth IRA and do so within the 60-day window, you will avoid the 10% penalty on early distributions.

The best way to illustrate how a Roth conversion works is by way of an example. Suppose two years ago the value of your traditional IRA was $250,000. However, because of market underperformance, it is currently valued at $150,000. If you were in the 25% marginal tax bracket, you would have paid $62,500 in federal income tax had you converted your traditional IRA two years ago. Luckily, if you were to convert the IRA today, you would only pay $37,500. Granted, you are going to be paying less tax but you also have less in assets but lets focus on the positive.

If you are already close to the top of your tax bracket, you may want to reconsider converting the entire value of your IRA as this could push you into the next higher bracket. The solution to that might be to convert a smaller portion at a time thereby staying in your current, lower tax bracket.

Unlike IRA contributions that can be made up until April 15th of the following calendar year, Roth conversions have a December 31st deadline. If you make the Roth conversion and then change your mind, all is not lost. You have until October 15th of the next calendar year to undo a conversion. If you do change your mind but already filed a tax return for the year, an amended tax return, Form 1040X will need to be completed in order to receive your refund of the taxes. So, for example, lets say that on November 28, 2008 you decided you wanted to convert all of your traditional IRA to a Roth. If for whatever reason, you decided on July 19, 2009 that it was a bad idea, you have until October 15, 2009 to undo the conversion.

If you are still hesitant about making the conversion, you may want to consider the following:

  • With a new administration in Washington in less than two months time, there is a strong possibility of an increase in taxes
  • Because investments are cheaper now (because of the market downturn), you will be able to buy more shares that when the market rebounds, will be worth more and will all be tax free

Although it may be one of the best times to convert a traditional IRA to a Roth IRA because of the downtick in the stock market as of late, a conversion may not be appropriate for everyone. There are instances where a Roth conversion would not make sense and others where you would be foolish to not convert. Discuss your personal situation with your financial or tax advisor to make the best decision for your specific circumstances.