There has been a lot of buzz lately about the benefits of converting a traditional individual retirement account (IRA) to a Roth IRA in 2010. That's in large part due to some recent tax law changes that can positively impact some people's retirement investment strategy. As a quick refresher, contributions to a traditional IRA are made with pre-tax dollars. That means your money can grow without being taxed until it is withdrawn. But a Roth IRA uses after-tax money, so your money grows without taxes for as long as it's invested in the Roth IRA.
Savers have always been able to roll over traditional IRAs to Roth IRAs, although income limits and other restrictions have made that process challenging. One challenge for those that made the switch meant having to pay the taxes due on the traditional IRA in one lump sum. This often meant a big financial hit to the saver, especially when the account balance was substantial.
Beginning in 2010, however, the income tax realized can now be paid over three years. That means you can postpone the tax ‘hit' until you file your taxes for 2011 and 2012. In practice, that means that - unless you owe estimated taxes - you don't actually have to come up with the cash until you file your taxes in 2012 and 2013. Plus, the $100,000 income limit on conversions has been lifted, so higher income earners who weren't able to participate in the past can now make the switch.
But there are still some important issues to consider. In an interview for the January 16, 2010 issue of MarketWatch,* reporter Chuck Jaffe spoke with John Leis, vice president of personal finance solutions for American Century Investments.
"One of the biggest challenges associated with this is that clients have heard or have interpreted that this is a good thing, so let's do it...," said Leis. But he explained that it's not that simple. "The biggest question facing individuals as we go through the process is, ‘How are you going to pay for the taxes and do you have the money to pay them?'" Leis added, "It certainly is an advantage that you don't need to have all of the money to pay in 2010, because the amount of tax dollars you are talking about can be significant. But if you don't have the money to pay the taxes without removing that money from your retirement savings, it may be that making the conversion is not the best idea for you."
The bottom line: Before deciding to convert your traditional IRA to a Roth IRA, do your homework and take time to talk with a Retirement Specialist or visit with your accountant.
*MarketWatch is an electronic financial newsletter published by The Wall Street Journal.