To Roth or Not To Roth – That is the Question

So 2010 is upon us and there is a lot of controversy regarding whether folks should convert their Traditional IRAs to a Roth IRA. Some of you might be wondering what exactly is a Roth IRA, well, here’s the basics:

A Roth is funded with after-tax contributions; the money grows tax-deferred; and withdrawals are TAX FREE!

In other words, you use money you’ve already paid taxes on to fund the Roth, and provided you meet certain qualifications you never have to pay taxes on that money again!

What is a Roth IRA Conversion?

A Roth IRA conversion then is taking money from a Traditional IRA, pulling it out and putting it into a Roth IRA where it will grow tax free.

Sounds good right?

Well, the problem is that whenever you do this you have to pay taxes on the amount you withdraw from your Traditional IRA.

So, let’s say you are converting $5,000 from your Traditional IRA — you would have to tack on 5G’s to your income for the year and pay tax at whatever rate you are at. It’s as if you earned an additional $5,000 of income for the year.

As many of you already know, one big change for 2010 is that anyone can convert to a Roth regardless of income level. Previously, if you made over $100,000 you could not convert to a Roth.

If you convert your IRA to a Roth in 2010, you now have a choice to pay all of your taxes in 2010 or average the taxes owed on the conversion over two years (i.e. pay in 2011 and 2012). Uncle Sam is giving you a choice on when you pay your taxes.

Don’t forget though that 2010 is the last year for the current low income tax rates. The current law plans for higher tax rates in 2011 — so, if you chose to average your tax payments over the two year period in 2011 and 2012, you might get hit with higher tax rates. That Uncle Sam – he’s always got an angle doesn’t he?

Should You Roth It?

Back to the question at hand. Should you convert to a Roth IRA or not?

Usually the answer to such questions is “it depends”. This might be a great year to convert your money to a Roth and potentially pay lower taxes than you would normally if you are in a lower bracket due to retirement or a layoff and you’ve got some cash on hand to cover your taxes!

This is important because if you are under 59 1/2 and use your IRA to pay the taxes on the conversion you’ll get whacked with a 10% penatly on top of the taxes!

Also, although the markets have rebounded significantly, account balances are still off their 2007 highs. If you convert when accounts are lower, it will result in less overall tax paid plust all the earnings and growth will be tax free!

Factors to Consider

• Do you have money to cover your tax liability? Having cash on hand to cover your taxes will help soften the blow.
• Will the money you convert push you into a higher tax bracket? If so, you probably don’t want to do it.
• Do you have non-deductible contributions in your IRA? No taxes are due on the non-deductible portion. *There are some additional factors to consider here that go beyond the scope of this post.
• Are you planning on applying for financial aid for yourself, your spouse or your child? Better think twice about the conversion – conversion income counts on your application.

Ultimately, whether you convert your Traditional IRA to a Roth will not determine your retirement success, there certainly are other factors to consider to help you make a great run at retirement.

Consider these factors and your overall situation to determine whether the Roth IRA conversion makes sense for you in 2010.

What do you think? Will you be converting to a Roth this year?

This article was authored by Jason Topp, and is reprinted from ChristianPF.com by permission.

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