In 2010 there is no income limitation that affects your ability to convert a Traditional Individual Retirement Account (IRA) to a Roth IRA. Until this year, you could not convert if your Modified Adjusted Gross Income (MAGI) exceeded $100,000, regardless of your filing status. This doesn’t mean that you should rush right out and do a conversion. There are numerous factors to consider in order to determine whether a conversion makes sense for you.
Let’s look first at the differences between Traditional IRAs and Roth IRAs. There are two types of Traditional IRAs, deductible and non-deductible:
With a Traditional Deductible IRA, you make (or have made) contributions with pre-tax dollars. The money in the account grows tax deferred. This results in all of your withdrawals from the IRA being subject to federal income tax. Up until the Tax Reform Act of 1986, all IRAs were what we now call Traditional Deductible IRAs. After that time, only certain individuals could deduct their contributions.
With the passage of the Tax Reform Act of 1986, individuals who had a retirement plan at work (like we do) could not deduct their IRA contributions if their income was over a certain level (see IRS Publication 590 for this and other information about IRAs). This resulted in what is now called a Traditional Non-Deductible IRA. Contributions to this type of IRA are made with already taxed dollars. This means only the earnings on your contributions are subject to federal income tax at the time of withdrawal.
Roth IRAs came around in the mid-90s. They are named after Delaware Senator William Roth, who advocated for their creation for years. Contributions to a Roth IRA are from already taxed dollars and the earnings are tax free if two conditions are met. First, you must be at least 59 ½ at the time of the withdrawals. Second, you must have had the Roth IRA open for at least five years.
Some of a Roth’s advantages are:
- If you are at least 59 ½ and the account has been open for at least five years, you will pay no taxes on your withdrawals.
- You can withdraw your contributions from a Roth IRA at any time without paying the 10% penalty if you are under 59 ½. However, there is an exception for money that was moved into a Roth by a conversion. That money must remain in the Roth for five years from the conversion date to avoid the 10% early withdrawal penalty if you are under 59 ½ when making the withdrawal. If you’re over 59 ½ – no problem.
- There are no Minimum Required Distributions (MRDs) with a Roth IRA. Traditional IRAs require that you begin taking MRDs once you reach 70 ½.
- If you continue to work past the age of 70 ½, you may continue to contribute to a Roth IRA if you meet the income requirements to do so. With a Traditional IRA, you are prohibited from making contributions once you attain 70 ½.
In order to convert to a Roth, you will have to pay taxes on any gain in your Traditional IRA. In the case of a Traditional Deductible IRA, that means you will pay tax on the entire conversion amount. In the case of a Traditional Non-Deductible IRA, it means that you will pay tax on your earnings.
Those who convert in 2010 will not have to report the conversion for one year and can spread the tax over two years. They would pay half the tax with their 2011 return (due 4/15/12) and half with their 2012 return (due 4/15/13).
What are some of the considerations in converting a Traditional IRA to a Roth IRA?
- What do you expect tax rates to be at the time you take your withdrawals from the Roth IRA? If you feel you will be paying taxes at a higher rate down the road, it might make sense to convert now, while your tax rates are lower.
- What do you think your income will be when you start taking withdrawals? Not everyone has a significant drop in income after they retire. A CSRS retiree with many years of service and a hefty TSP balance (let’s call him “Mr. Lucky”), might have a level of retirement income equal, or close to equal to the pre-retirement level.
- How large is your traditional IRA? How much tax will you have to pay at conversion?
- Can you afford not to touch the Roth for a five year period? If you can’t, you’ll owe tax on the earnings you withdraw.
- Will making the conversion affect your income level and result in you paying a higher rate for your Medicare Part B premiums? Of course, if you’re not yet eligible for Medicare, this is not an issue.
There are many things you should consider before you make a decision on converting a Traditional IRA to a Roth IRA, and not all of them have been addressed in this article. As with many other decisions, there is no one-size-fits-all answer. Consider consulting with a financial professional before making a decision on converting.
