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Roth conversions prove popular

By Barbara Whelehan · Bankrate.com
Friday, January 10, 2014
Posted: 11 am ET

Remember all the media hype about Roth conversions in 2010? Yes, Bankrate participated in the hoopla -- er, I mean, we published a few stories about the merits of doing a Roth conversion, too.

Who took advantage of 2010 Roth conversions? A recent IRS report reveals that the amount of money converted to Roth IRAs rose to $64.8 billion in 2010, an 800 percent-plus increase over the previous year. "This explosive growth was primarily due to new tax provisions expanding the availability of conversions to all income levels," according to the report.

In 2010, income restrictions were lifted and for the first time, people earning more than $100,000 were allowed to convert their traditional IRAs to a Roth IRA. Furthermore, they were able to spread the income tax liability over two tax years -- 2011 and 2012.

A look at the IRS Roth conversion numbers reveals that 57 percent of those who converted earned more than $100,000 that year. And their assets represented nearly 80 percent of the amount that was converted to a Roth. So the target audience took advantage.

But people of all income levels participated. The balance of people who converted to a Roth -- 43 percent -- earned less than $100,000. Their assets totaled 21 percent of the total amount converted that year.

What's better -- Roth or traditional?

Recall that a traditional IRA is generally tax-deductible. It's taken off the top of your income, so you get the tax break upfront as you contribute. You have to pay taxes at ordinary income tax rates -- your tax bracket level -- at the time you take distributions, which hopefully is during retirement.

Conversely, a Roth IRA contribution is made with money you've paid taxes on. It grows unfettered and free and you don't pay taxes when you take it out at retirement. In fact, you don't even have to take it out during retirement at all. You can pass the tax break on to heirs.

So does it always make sense to convert? "Many folks are attracted by Roth IRAs' tax-free setup," says Kay Bell, Bankrate's tax editor. "These are also the folks who have other money with which to pay the conversion taxes and who are confident they'll be in higher tax brackets later, so they wanted to take advantage of previously lower tax rates."

But it doesn't make sense for everyone. "A lot of people will be in lower tax brackets when they take IRA distributions," says Bell. "They're not worried about what they'll owe many years down the road. And for them, now, a traditional IRA and possible tax deduction are important."

In other words, whether it makes sense to convert depends on your personal financial situation. But a Roth conversion is one of many retirement planning options to consider. While spreading the tax liability over two tax years is no longer an option, conversion still is.

But for folks who expect to be in a lower tax bracket during retirement, contributing to a Roth IRA or Roth 401(k) might make more sense than paying for a Roth conversion. Roth funds give you more tax flexibility as you strategize your retirement income needs, which could come in handy during your golden years.

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Follow me on Twitter: BWhelehan.

Barbara Whelehan is a co-author of "Future Millionaires' Guidebook," an e-book by Bankrate editors and reporters. It is available at Amazon, Barnes & Noble, iBookstore and other e-book retailers.

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