Pros and Cons of IRA Conversions

Many financial advisors have been recommending that their clients consider converting traditional IRAs to Roth IRAs as a result of new rules that eliminate income limits on those converting IRAs and that allow some tax payments on conversions to be delayed. Whether a conversion is the right move for you will depend on your individual situation, so do your homework before deciding to convert. Among other things, consider these ten pros and cons of IRA conversions.

Pros of IRA Conversions

No Future Taxes. Once you convert a traditional IRA to a Roth IRA and pay the income taxes on the conversion, you're done. You (or your heirs) won't have to pay taxes on capital gains, dividends or other income earned on the funds in the Roth IRA or on withdrawals from it.

No Withdrawal Requirements. The money can stay in a Roth IRA as long as it suits you. There are no minimum distribution requirements with a Roth IRA as there are with a traditional IRA (beginning at age 70 ½).

Taxes May Be Less Today Than in the Future. A conversion of a traditional IRA to a Roth may be advantageous if you expect to be in a higher tax bracket when you plan to withdraw the funds than you are today.

Tax Payments on a Conversion Can Be Delayed. Currently, rules for tax payments on the conversion of a traditional IRA to a Roth IRA are favorable, since the taxes don't have to be paid in full until 2012. Income on 2010 conversions can be reported 50% in 2011 and 50% in 2012, with the taxes paid at your federal income tax rates in those years. However, you do not have to delay reporting the taxable income. If, for example, you believe that your income tax rate will be higher in 2011 and 2012 than in 2010, you can choose to report all of the conversion income in 2010.

No Penalties on Withdrawals. No matter what your age, you can withdraw money penalty-free from a Roth IRA conversion after five years. This is different from other IRAs, which generally require you to keep the funds in the IRA until age 59 1/2 or pay a 10% early withdrawal penalty on any withdrawals before you reach that age.

Cons of IRA Conversions

Pay Taxes on Conversion. When you convert a traditional IRA to a Roth IRA, you are liable for income taxes on the entire amount converted.

Taxes May Be More Today Than in the Future. If you believe that your tax rate is likely to be lower in the future when you expect to withdraw money from your IRA, your total tax bill on the funds in your traditional IRA may be lower if you don't convert. Also, remember that tax payments on future withdrawals may be made with less valuable dollars depending on the inflation rate between now and when the taxes are paid.

Need Cash to Pay Taxes. It is preferable to use cash on hand not IRA funds to pay the taxes on an IRA conversion. If you must use money in your traditional IRA to pay the taxes due on a conversion, you may lose much of the benefit of conversion because you will start with a lower balance.

Penalty May Be Due. If you convert your traditional IRA to a Roth IRA before age 59 ½ and use money from the IRA to pay the taxes, you will have to pay a 10% penalty on the amount withdrawn to pay the taxes, as well as the income taxes, reducing your starting balance even further.

Conversions Need Time to Work. If you will need to withdraw money from your IRA within a relatively short period of time, converting to a Roth IRA may be counterproductive, since you must pay a 10% penalty on withdrawals made in the five years after the account is established.

IRA conversion and withdrawal rules can be tricky, so before you decide whether an IRA conversion is right for you, be sure to talk to a financial advisor with expertise in this area.

Sources:

Thomas Corley, ezinearticles.com, Roth IRA Conversion - Pros and Cons

Robert Powell, www.marketwatch.com, 12 traps to avoid when converting to a Roth Robert Powell

Rande Spiegelman, www.schwab.com, 2010 Roth Conversion: Look Before You Leap

Roy Lewis, www.fool.com/money, Roth IRA early withdrawals and penalties