Fidelity Investments reports that a survey of 800 customers finds very little understanding of Roth IRAs. USAA, another big financial-services firm, did a similar survey over the summer and found the same thing. Both firms say the lack of understanding could be very costly to investors next year, when special rules take effect permitting holders of regular IRAs to convert them into Roth IRAs regardless of their taxable income levels. Right now, less than 10 percent of those surveyed plan to take advantage of the 2010 conversion rule. The companies say the percentages likely would be much higher if investors better understood Roths and the possible conversion benefits.
[See A Guide to Roth IRA Conversions.] This could be a big deal for you. It's certainly worth your while to see if converting some or all of your retirement accounts into Roth IRAs makes sense.
As a refresher, traditional IRAs are funded with pre-tax dollars and defer taxes on investment gains. When funds are withdrawn from the account, however, they are taxed as ordinary income.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by contrast, are funded with post-tax dollars but they allow investment earnings to avoid taxes when the funds are withdrawn from the account.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 used 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 limit on conversions goes away. Keep in mind that in order to enjoy tax-free earnings from your new Roth, you'll have to pay income taxes on the pre-tax contributions and investment gains in the tax-deferred accounts you wish to convert. That might be a big check to write. But if, like most people, you suffered market losses in your retirement accounts in 2007 and 2008, this might be the least painful time to write such a check. Also, for conversions made in 2010, the government will give you two years to pay this tax bill. Conversions made after 2010 will have to pay all taxes in the single year the conversion is made.
There are many factors that can determine if you should take advantage of this new conversion opportunity. The single most important variable is how many years you expect to be drawing down earnings from your retirement account. If you're in your late 50s, for example, you very well might have 25 to 30 years of retirement-account payouts. Getting all of these earnings tax-free makes a Roth IRA very attractive.
USAA lists these five reasons to consider converting:
Fidelity says investors should consider converting to a Roth if they expect at least 10 years to pass before making withdrawals, think tax rates will be higher in the future, or plan to leave savings to heirs.
Morningstar has an IRA conversion calculator that can help you with some of the heavy lifting. However, before converting, you will need to gather details on your existing retirement accounts. In particular, ask your existing account manager to provide you with the amount of your tax bill. And make sure you understand how this amount was calculated.