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A Roth-IRA conversion in 2010

Chris Farrell Apr 28, 2009

Question: As I understand it, Congress has lifted the income limits for Roth IRA roll-overs starting in 2010. How likely do you think it is that Congress will leave that tax change in place? Paul, Seattle, WA

Answer: My best guess–and it’s just that, a guess–is the shift in the Roth-IRA conversion rule will hold for 2010. After that it all depends on whether the Obama Administration pursues dramatic tax reform and manages to get Congress to agree to a major overhaul of our Byzantine tax code. The Administration has appointed a tax reform commission headed up by former Federal Reserve Board chairman Paul Volcker, but with everything that is going on in the economy and markets it hasn’t had much traction.

For the moment it looks like 2010 is fast becoming the equivalent of a conversion gold rush. Here’s why: Up until now, you could only convert a traditional IRA into a Roth-IRA if your modified gross adjusted income was under $100,000. The income limit lifts in 2010. What’s more, when you convert from an IRA to a Roth you owe income taxes on the amount converted. The reason is a traditional IRA is funded with pretax dollars while a Roth is funded with after-tax dollars but withdrawals are tax free in retirement. Well, the 2010 conversion amount may be included as taxable income in 2011 and 2012. That helps spread out the tax bite. It’s a one-time perk.

To convert or not to convert, that is the question. There are many factors to consider, but for many people the answer will be yes. The benefit of tax free withdrawal is huge. The argument for converting strengthens the longer your money can compound after conversion and before retirement. It’s also important to have other savings on hand to pay the tax bill. Another advantage of the Roth is there is no required minimum distribution at age 70 ½ as there is with a regular IRA. For those with substantial assets converting to a Roth may make financial sense simply from an estate planning perspective.

There are many twists and turns to this conversion story. For instance, should you pay the tax tab in 2010 or spread it out depend on whether you believe the money you make off the delayed payment will offset the risk of a higher tax bill. What will happen to your income in 2012? Maybe your income will plunge in which case you’d probably elect to pay the tax over two years. But if there’s a chance of a big bonus in 2012 you’d get rid of the tax liability in 2010.

One place to get started researching the economics of conversion for your household is at web-based calculator, like this one.

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