Should you, or shouldn't you?

 
2010 marks the beginning of a significant change to the Roth IRA legislation, which allows most taxpayers to convert a traditional IRA to a Roth IRA and have future earnings free from income tax. This opens the door to many opportunities for taxpayers previously excluded under the $100,000 Modified Adjusted Gross Income (MAGI) limitation. Of course, this comes with a price – payment of the income tax at the time of conversion. For 2010 conversions only, you may elect to defer and split the income, reporting half in 2011 and half in 2012. 

Estate Planning

Converting a traditional IRA to a Roth IRA can be a great way to increase the net benefit to heirs of large estates. By using assets outside of the IRA to pay the tax liability now, you can effectively reduce the size of your taxable estate and create an account that can grow tax free with no minimum distribution requirements during your or your spouse’s lifetime. While the Roth IRA will still be included in the estate as a taxable asset, your heirs can enjoy income tax-free distributions throughout their lifetimes. Charitable intentions must be considered prior to converting an IRA, as it likely makes sense to satisfy these bequests with tax-deferred assets. 

Recharacterization

A process called “recharacterization” allows you to wait until you file your return for the year in which you convert to see if the strategy works (which could be as long as 21 months if you convert early in January and extend to October 15). If the value of the new Roth IRA account drops due to a dip in the market, you can recoup your original tax liability by “recharacterizing” the remaining assets back to a traditional IRA. It’s best to convert early in the year to allow more time to recharacterize if necessary. 

Five-Year “Lock up”

Each Roth IRA conversion is subject to a five-year waiting period. If you are under 59 ½ and a “qualifying event” is not met (death, disability, or first-time home purchase), withdrawals will be subject to a 10 percent penalty on the entire distribution and additional income tax on earnings if five years have not passed since January 1 of the year in which you convert. If you’re over 59 ½ or satisfy a “qualifying event,” you can withdraw the original conversion amount at any time tax and penalty free, but it will be subject to income tax on earnings until the five-year requirement is satisfied.

It’s important to note that this strategy generally isn’t recommended unless sufficient assets are available outside of the IRA to pay the tax liability. In addition, the conversion doesn’t have to be “all or nothing,” as partial conversions often make sense. Consulting with your tax and investment advisors on your individual circumstances will help you determine if a Roth IRA is appropriate for you.