The rush to convert: Why 2010 will be the year of the Roth IRA

Think of 2010 as the year of the Roth IRA. Beginning January 1, the rules governing who can invest in a Roth will be modified, allowing anyone with an existing traditional IRA to take advantage of a Roth -- and the special post-retirement tax breaks that this investment vehicle offers.

The more lenient rules are a result of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), which was signed into law by President Bush in May, 2006. Under the new rules, the income limits for converting a traditional IRA to a Roth IRA will no longer apply. So anyone with an existing IRA can take advantage of the Roth. Establishing and making contributions to new Roth IRAs will not change, however. For those who think that they will be paying a much heftier tax rate come retirement than they do now, this is good news. But they will have to act fast: The new rules are only in effect for one year.
Typically, eligibility to contribute to a Roth IRA phases out at certain income limits. In 2009, for single taxpayers, the Modified Adjusted Gross Income (MAGI) limit for a full contribution is $105,000; for married taxpayers filing jointly, the limit for a full contribution is $166,000. The traditional rules were also restrictive when it comes to converting traditional IRAs into Roth IRAs. In 2009, individuals with MAGI of $120,000 or more and married taxpayers filing jointly with MAGI of $176,000 or more were not allowed to move assets from traditional IRAs into Roth IRAs. Phaseouts, contribution limits and other restrictions also applied, making the Roth IRA an impossibility for many taxpayers.

That may not seem like such a big limitation to some people. After all, you have to pay taxes on any contributions you make to a Roth, while traditional IRA contributions are tax deductible. That means taxpayers taking advantage of the newly-modified rules, will still be responsible for paying income tax on the conversion. However, the income tax due on conversions that occur in 2010 can be paid over 2011 and 2012, instead of in one year. The tax on the conversion will be paid at the taxpayer's applicable tax rates in the year that the tax is actually paid. Depending on your level of income, the additional income from conversion could boost you into a higher income tax bracket. If you're worried about the expiring Bush tax cuts increasing your rate, you can pay early.

But here is the real perk of the Roth. Distributions aren't taxed so contributions generally grow inside the Roth IRA federal income tax-free. So for those who think that they will be paying a heftier tax rate come retirement than they are at the time they convert or make a contribution to a Roth, it probably makes sense to take the tax hit now.

Of course, that forces you to do a little crystal-ball gazing. It's difficult to predict whether or not tax rates will be higher years from now. While taxpayers generally find that rates dip as they reach retirement, that's not always the case. And while we tend to believe that rates continue to climb, consider this: in 1997, the top tax rate was 39.6% (tables download as a pdf), compared to 2009's top tax rate of 35%. However, with a federal deficit that keeps rising rapidly, tax rate increases aren't out of the question.

A Roth also tends to work best for younger taxpayers. Remember, growth inside the Roth is generally income-tax free. The longer the assets remain inside the Roth, the more likely there will be significant tax-free growth. For the Roth to be the most beneficial, the growth inside the plan should exceed the income taxes paid upfront for a conversion or contribution.

Irrespective of age and income tax rates, Roth IRAs have a few more advantages. There are no minimum required withdrawals during your lifetime (some quirky things happen after death). And unlike a withdrawal from a traditional IRA, any nontaxable withdrawals from a Roth IRA won't affect your Social Security benefits.

In all cases, a conversion is most effective if you have cash outside of the IRA to pay the taxes. If you have to raid the IRA to pay the tax, you'll need to figure that into your calculation. For example, if you're converting $20,000 into a Roth, and you're in a 28% bracket, you'll pay income tax of $5,600. If you can pay the $5,600 from another source, the entire $20,000 will grow tax-free. If you dip into the Roth to pay the $5,600 in tax, you're left with $14,400 - at today's interest rates, you would have to wait quite awhile to recover your initial investment.

There are clearly some real advantages to making a conversion to a Roth in 2010. That doesn't mean it's the best plan for everyone. Before making the switch, consult with your tax or financial advisor to see if a conversion makes sense for you. As with any provision in the Tax Code, there are caveats, restrictions and exclusions that might apply. But don't panic: if you have buyer's remorse, you can reverse the conversion up until the moment you file your return, including extensions.