Converting the balances of your IRAs, 401(k) rollovers and other qualified retirement plans into Roth IRAs will become much more attractive next year because of changes in federal rules. Still, such conversions should be carefully considered by investors. It's not too early to begin planning for this process.
As a refresher, traditional IRAs are funded with pre-tax dollars and defer taxes on investment gains. When funds are withdrawn from the account, they are taxed as ordinary income. Roth IRAs, by contrast, are funded with post-tax dollars but they allow investment earnings to avoid taxes when the funds are withdrawn from the account. Roth IRAs don't make sense in pre-tax investment accounts and they can't be opened by taxpayers making more than $169,000 (joint returns) or $116,000 (separate returns). Furthermore, conversions of traditional retirement funds into Roth IRAs have not been permitted for households with annual incomes above $100,000.
Next year, however, the income ceiling for Roth conversions will be dropped, allowing anyone to convert as much of their qualifying retirement accounts into Roth IRAs as they wish. Of course, they will have to pay income taxes on their fund balances when they convert. But steep investment reversals in many retirement accounts may make that tax hit easier to take, and will guarantee that any market rebound in investment values will never be taxed if funds are switched into a Roth account. Also, the government is allowing conversion taxes to be spread over two years: 2010 and 2011. Taxes stemming from conversions made after 2010 will be fully due in the year of conversion.
With retirements stretching out 20 or 30 years, the value of tax-free withdrawals becomes an increasingly attractive feature of a Roth IRA. Christine Benz, personal finance editor at Morningstar, has written an informative overview of the conversion decision, and Morningstar provides a useful conversion calculator to help determine if conversion makes sense. Here are other things you should do to evaluate the conversion of some or all of your IRA balances into a Roth IRA next year:
Figure out how long you will live. Hey, no one said it would be easy! But seriously, this is an important number and you can get pretty close. Northwestern Mutual has a Longevity Game that incorporates actuarial data based on health and lifestyle variables: do you smoke, are you overweight, and so on. Then you factor in the life spans of your close relatives. The bigger the number produced by this exercise, the better a Roth IRA conversion will look. You'll have more years to enjoy the tax-free use of your Roth investment gains and, of course, more years over which to recover the tax hit you take on the conversion itself.
Determine how money you have in eligible accounts, and how much of it came from post-tax sources. When you convert to a Roth, you don't need to convert all of your retirement accounts, and you may need to limit the conversation amounts due to the income-tax bill created by the conversion. You must pay taxes on any retirement funds that were not taxed when they were placed into the account you want to convert. Your existing IRAs and 401(k)'s are likely funded entirely with pre-tax money, so you’d pay taxes on those contributions--plus on whatever investment earnings they have produced. Some investors, however, have placed post-tax dollars into retirement plans, usually because they wanted to take advantage of deferred taxes on investment gains, even though they had exceeded the limits of pre-tax contributions. If you have any after-tax amounts in your retirement programs, they will not be subject to taxes when you convert. However, the conversion process will be more complicated because federal rules prevent selective conversion of post-tax account values. You will need to add up all your retirement account values, calculate the percentage of funds subject to conversion taxes, and make sure your conversion includes at least this percentage of funds.
Determine what you federal tax rate will likely to be in 2009, and how you see it changing in the years ahead. If your tax rate this year is likely to sharply drop in the near future, it might make sense to wait to make the conversion. If so, you have to balance that lower tax rate against the prospect that the funds you wish to convert will have grown in value during the intervening year. You also will have to pay the full tax bill in a single year instead of being able to take two years. If your future tax rate is likely to be sharply lower than it now is, however, it might make sense for you to forgo the conversion.
Think about placing new funds into a Roth IRA. If your income permits, you can place up to $5,000 in new funds in a Roth IRA ($6,000 if you're over the age of 50), and so can your spouse. IRS Publication 590 has the details.