Roth IRA Conversion Rules Change in 2010

On January 1, 2010, an important change in Roth IRA rules takes effect. Unlike traditional IRAs (tax deductible type) where withdrawals are taxed as ordinary income when taken, no portion of Roth IRA withdrawals are ever taxed as long as withdrawals occur after age 59-1/2 and the Roth IRA account has been open at least five years. This tax free benefit is available since Roth IRAs are funded with income already taxed but the real benefit is the fact that earnings over the life of the account are also exempted from federal taxes. Since the Roth IRA was launched in 1997, eligibility for opening a Roth IRA account or converting a traditional IRA to a Roth Ira has been subject to Modified Adjusted Gross Income (AGI) thresholds. For example, as noted in IRS Publication 590, Individual Retirement Arrangements (IRAs), for tax year 2009, married taxpayers filing jointly with a modified AGI of $169,000 or single taxpayers with a modified AGI of $101,000 were not eligible to open a Roth IRA account. That portion of the Roth IRA rules remains in effect in 2010. Also since 1997, all taxpayers with an adjusted gross income of $100,000 or more were not eligible to convert a traditional IRA to a Roth IRA but there we find the important change in the Roth IRA rules for 2010. As noted by James Cox, Managing Partner of Harris Financial Group, in his appearance on CNBC's Squawk on the Street, December 29, 2009, that income threshold has been removed effective January 1, 2010, and all taxpayers regardless of adjusted gross income may convert existing traditional IRAs to Roth IRAs.

Advantages of Converting to a Roth IRA

There are some important advantages to a Roth IRA when compared to a traditional IRA. As mentioned Roth IRA withdrawals and earnings are exempt from federal taxes. Another significant advantage is that unlike traditional IRAs where the IRS requires that minimum distributions be taken at age 70-1/2 (IRS Publication 590), retirement funds can be kept in a Roth IRA account indefinitely without penalty. This provides more flexibility in retirement and also serves to make the Roth IRA an excellent estate planning tool. If you do not need to tap the funds in a Roth IRA account, the account can be passed on to your heirs and structured in such a way that those who inherit a Roth IRA also will never have to pay federal taxes on any withdrawals or earnings (IRS Publication 590).

Tax Considerations

It is important to note, that when a traditional IRA is converted to a Roth IRA, taxes become due on conversion. This is due to the fact that traditional IRAs are funded with pre-tax contributions so taxes are deferred on both contributions and earnings. The amount of tax is based roughly on the taxpayer's marginal tax rate. For illustrative purposes, as shown at About.com: Tax Planning: 2009 Tax Rate Schedules, the marginal federal tax rates for 2009 for single taxpayers with incomes between $82,250 and $171,550 was 28% and for married taxpayers filing joining with incomes between $67,900 and $137,050 was 25%. Thus using the single taxpayer as an example, a traditional IRA account valued at $100,000 converted to a Roth IRA would result in a tax bill of approximately $28,000 (100,000 X .28). Still, as observed by James Cox, projected tax free earnings and future tax savings resulting from the conversion would likely offset the taxes resulting from conversion for taxpayers earning more than $100,000 per year and who had a decade or more remaining before retirement.

Cox also noted that congress has made the tax bill resulting from conversion a pill that can be a bit easier to swallow by passing legislation that allows taxpayers to convert in 2010 but postpone payment of the tax. Legislation provides that taxes can be paid over the next two tax years with half being paid in 2011 and the balance paid in 2012.

Who Should Convert

There is a wealth of online interactive calculators available to help you determine if converting your traditional IRA to a Roth IRA makes sense for you. One easy to use calculator can be found at the Motley Fool financial web site: Roth IRA Conversion Calculator.

While many people could benefit from converting their traditional IRA to a Roth IRA, the wisdom of making a conversion of course will depend on specific circumstances. For that reason you should seek the advice of your financial advisor or tax planning professional before making your decision on whether to take advantage of the new Roth IRA conversion rules.