The purpose of this memorandum is to advise you that for tax year 2010, irrespective of your income, you have the ability to convert your IRA and in some cases other retirement accounts, into a ROTH IRA.
The primary advantage of a ROTH IRA is that the earnings in a ROTH IRA grow tax free and when you ultimately take the money out, the distributions are also tax free. The downside of converting to a ROTH IRA is that you have to pay the tax on the amount you convert.
In prior years if your income was $100,000 or less, you could have always converted into a ROTH IRA. The new wrinkle is that those with high incomes can now also convert their IRA’s et al into ROTH IRA’s and the amount converted is not taxed until 2011 and 2012.
The benefit of an IRA has always been that the deductible contribution was made when you were in a high tax bracket, the earnings would grow tax free until you retired and then you would pull some of the money out each year and paid tax accordingly. If your tax rate was lower when you retired, so much the better.
There is clearly an economic advantage to converting to a ROTH IRA if 1.) You will be in the same or less tax bracket when you retire than when you report the distribution as income (50% in 2011 and 50% in 2012) and 2.) You pay the taxes from funds other than the IRA. (In other words, the dollars in the IRA go in full into the ROTH IRA and you have other savings or funds from which to pay the taxes.) In substance you are switching investment assets which are taxed to investment assets that are not taxed.
By converting to a ROTH IRA you also
- Eliminate the disadvantage of an IRA where long term gains and dividends are converted to ordinary income and
- You are not subject to the Required Minimum Distribution (RMD) rules.
In doing such an analysis of whether or not to convert there are a number of assumptions that must be made. For example, life expectancy, expected tax rates, your investment allocation, current needs for liquidity, expected retirement age, etc. Furthermore, higher income in 2011 and 2012 could result in higher taxes on social security income or higher costs of tuition if you are unable to obtain grants based upon low income. I have looked at several of the projection software packages and found them lacking. However, most will give you a ball park idea of the economic consequences.
Unless you specifically request me to advise you, I will assume you are making your own determination as to whether or not you should be switching to a ROTH IRA.