Traditional vs. ROTH IRAs
Should you convert all or a portion of your traditional IRA assets to a Roth IRA account? Until recently, retirement investors desiring to convert all or a portion of a traditional IRA to a Roth could only do so if their modified adjusted gross incomes (MAGIs) were $100,000 or less. But beginning in 2010 and thereafter, this restriction will be removed, permitting retirement investors at any income level to convert their assets.
For those who convert in 2010, the federal income taxes triggered by this action can be paid over two tax years, which lessens the immediate tax bite. But for conversions in subsequent tax years, the resulting tax payment must be paid in the tax year in which the conversion takes place.
Whether a conversion is right for you depends on the amount of time you plan to leave the assets invested, your estate planning strategies, and the federal income tax bill that a conversion is likely to trigger.
Two Types of IRAs
Each type of IRA has its own specific rules and potential benefits summarized below.
Traditional IRA |
Roth IRA |
|
Maximum Annual Contribution |
$5,000 for single taxpayers and $10,000 for couples filing jointly for 2009. An additional $1,000 “catch up” contribution is permitted for each investor aged 50 and older who has already made the maximum annual contribution. | Same as traditional IRA. |
Income Thresholds for Annual Contributions |
None, as long as the account holder has taxable compensation and is younger than age 70 1/2 by the end of the year. | Single taxpayers with MAGI in excess of $120,000 and married couples filing jointly with MAGI in excess of $176,000 are not eligible in 2009. Income thresholds are indexed annually. |
Deductibility of Contribution |
Yes, if account holder meets requirements established by IRS. | No. Contributions are made with after-tax dollars. |
Contributions AfterAge 70 1/2 |
Not permitted. | Permitted if owner has earned income. |
Required Minimum Distributions (RMDs) After Age 70 1/2 |
For the 2009 tax year only, RMDs are not required, but are mandatory in 2010 and thereafter. | Not required at any age. |
Taxes on Distributions |
Qualified distributions are taxed as ordinary income. Withdrawals before age 59 1/2 may also be subject to a 10% penalty.1 | Qualified distributions are tax free. Withdrawals from accounts held less than five years or before age 59 1/2 may be subject to taxes and a 10% penalty.1 |
Conversion: Potential Benefits …
Potential benefits of converting from a traditional IRA to a Roth IRA include:
- A larger sum to bequeath to heirs. Since RMDs are not required from Roth IRAs, investors may leave the money invested, which may result in a larger balance for heirs.
- Tax-free withdrawals for those who are age 59 1/2 or older and who have had the money invested for five years or more.
… As Well as a Potential Drawback
Investors who convert proceeds from a traditional IRA to a Roth IRA are required to pay taxes on the amount that is rolled over. Because IRA contributions are typically made on a before-tax basis, the full amount of the conversion is usually taxable at ordinary rates. If you have a nondeductible traditional IRA, investment earnings will be taxed but the amount of your contributions will not. The conversion will not trigger the 10% penalty for early withdrawals.
Should You Do It?
A conversion may be more attractive the further you are from retirement. The longer your earnings can grow, the more time you have to compensate for the associated tax bill. Careful consultation with your financial advisor and tax professional is a good idea before you make your choice.
*IRA account holders (both traditional and Roth) may make qualified withdrawals before age 59 1/2 only if they meet specific criteria established by the IRS (disability, qualified first-time home buyer, and others). Consult www.irs.gov for additional information.
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