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Would you benefit from a Roth IRA conversion?
A Roth IRA conversion seems like it might be a good idea, but what are the pros and cons and what do you need to know?
We believe that most investors should consider having a Roth IRA as part of their overall retirement plan because they offer tax-free growth potential and withdrawals,1 which has the potential to help minimize taxes and maximize retirement savings. But Roth IRAs have income restrictions, so not everyone has access to one today.
There's good news. If you've been shut out of a Roth IRA because your income is too high, you now may finally be able to have one. On January 1, 2010, the income limits for converting traditional, rollover, SEP, and SIMPLE IRAs, and 401(k) or other workplace savings plans with former employers, to a Roth IRA were removed. Before this change, only people—single or married and filing jointly—with modified adjusted gross incomes of $100,000 and below could convert. (There are still income limits for contributing to a Roth IRA in 2010 and beyond.)
Factors to consider before converting
The decision to convert needs to be made with care and should include a consultation with your tax advisor. Generally, it may make sense to convert if you:
Special option for paying taxes on 2010 conversions
If you convert this year, you may get a bit of a break. As long as you don't withdraw the amount you convert from the Roth IRA before 2012, you can include half of the conversion in your 2011 return and the other half in your 2012 return. While spreading out the tax bill from your conversion over two years may sound appealing you should think carefully about the pros and cons. For instance, it may make it easier for you to come up with the money to pay the taxes on the conversion over multiple years. Plus it allows the potential for the Roth account to grow tax free immediately while the taxes on the conversion have been deferred. On the other hand, if you defer taxes, keep in mind that tax rates could go up in 2011 and 2012 or your income may be higher than expected. This may make your deferred tax liability higher than if you had paid it all at once.
How much to convert?
If you determine conversion is right for you, the next consideration is "how much?" For example, as discussed above, you're more likely to benefit from a Roth IRA conversion if you can pay the tax cost for that conversion without using the proceeds. Therefore, one rule of thumb is to convert an amount based on the taxes you can afford to pay using non-retirement accounts. Additionally, even if you can afford to pay the taxes on the entire amount, you still might want to consider partial conversions over several years so the income from the conversion is not taxed in a higher bracket than your current one.
While a conversion does finally allow many high-income investors the opportunity to have a Roth, it's important that you analyze your situation and are comfortable with your decision. (See below for a summary of some of the common situations where an investor may benefit from a Roth IRA conversion.) It does ultimately come down to your assessment of the tax cost. How much tax will you pay if you convert now versus what you expect to pay when you withdraw the money during retirement?
Investing involves risk, including the risk of loss.
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