There is no denying the benefits of converting money from a traditional IRA to a Roth retirement account.
Not only do the earnings in a Roth grow tax-free, but there's no minimum distribution age attached, allowing your money to work longer and harder during retirement.
Distributions from a traditional IRA, meanwhile, must begin by age 70 1/2.
Another Roth advantage is that you can take early withdrawals penalty-free (as long as the account has been open at least five years) for any reason so long as you limit your withdrawals to the initial principal.
Income earned from investments can also be withdrawn to cover qualified expenses, including the purchase of a first-time home, medical insurance premiums or higher education.
By contrast, distributions from a traditional IRA before age 59 1/2 will generally cost you a 10 percent penalty.
Who might benefit from a conversion?
- Young workers who are in a lower tax bracket
- High-income earners ineligible to contribute directly to a Roth
- Individuals near age 70 ½ who won't need the money within five years
- People who plan to pass on their IRA through an estate
An open window?
So why doesn't everyone make the switch?
For starters, not all taxpayers qualify for a Roth conversion -- at least not yet.
Currently, if your modified adjusted gross income is greater than $100,000, you are not eligible to roll money from a regular IRA into a Roth regardless of filing status.
However, new rules under the Tax Increase Prevention and Reconciliation Act of 2005 eliminate the income limit for Roth conversions beginning in 2010.
"If you had no prior IRAs and you are making too much money to contribute to a Roth, you can establish a nondeductible traditional IRA now, and then in 2010 roll it over into a Roth and recognize only the tax on earnings," says Nick Kaster, senior analyst for CCH tax services firm in Riverwoods, Ill. "Now, people who typically would be phased out of Roth IRAs because of higher incomes can effectively get a Roth by means of conversion."
The law also allows retirement savers who convert in the year 2010 (and only in 2010) to spread out any taxes they owe over the following two years -- 2011 and 2012.
As such, if you convert to a Roth in 2010 and owe $30,000 in taxes, you can pay $15,000 in 2011 and the remaining $15,000 in 2012.
The removal of the earnings limit applies to conversions only.
The existing income ceilings remain in effect for new accounts and for contributions to an existing Roth IRA.
Who should think twice about converting?
- IRA holders who cannot pay the tax bill with nonretirement savings
- People who may move into a higher tax bracket if they convert
- Older individuals who will need the money within five years