Does a Roth IRA Conversion Make Sense for Me?

In 2010, the U.S. Congress passed legislation allowing individuals to convert their conventional IRA plans to a Roth IRA, with payments on any taxes from the conversion spread out over 2011 and 2012.

Many people are now asking is it a good idea for me to convert to a Roth?

Before we look at the advantages and disadvantages of a Roth IRA Conversion, let's look at the types of Individual Retirement Accounts. IRAs come in a variety of flavors, including conventional, SIMPLE, and Roth. Each type of IRA has different features.

You are probably already familiar with types of IRAs if you are reading this article, and probably even own one or more. But just in case, here is a general review of the different IRA types:

Conventional IRAs = Tax Deferred Growth

A conventional IRA keeps allows your retirement funds to grow tax-deferred until age 69 1/2, when you are required to take a portion of the retirement account balance as a distribution, and then your earnings will be taxed, at whatever rate you are paying during your retirement years. During the years before you retire, your contributions to a conventional IRA can also be used as itemized deductions if your gross income doesn't exceed $75,000 a year. Conventional IRAs can reduce your tax payments in the short term, but you will pay up when you retire, when you are later required to pay taxes on the earnings of your retirement funds.

A conventional IRA can hold all kinds of investments, including stocks, bonds, mutual funds, exchange traded funds, etc.

Pros

Tax deductions while you pay into the traditional IRA. Tax-deferred growth of your investments.

Cons

You will be required to take payments from your conventional IRA, called a distribution, at age 69 1/2, whether you need it or not. This is Uncle Sam's way of guaranteeing that he gets a share back in the form of taxes.

Roth IRAs Mean Tax-Free Growth

A Roth IRA doesn't have the up-front tax advantages for middle-class tax-payers that a conventional IRA does. Your contributions to a Roth IRA have already been taxed once. However, Roth IRAs grow tax free. You will never have to pay taxes on the money invested in a Roth IRA. But there's more. Because the U.S. government doesn't tax the earnings on a Roth IRA, there are also no minimum distributions.

Think about that for a moment. If you are fortunate enough to have alternate sources of income during your early retirement years, wouldn't you want to control when and how the money in a Retirement Savings Plan is withdrawn? Perhaps you could leave your Roth IRA untouched for 5 years after your retirement, allowing the earnings to grow and compound a little more!

Roth IRAs can be left to designated beneficiaries, as part of an estate plan, and they won't have to pay taxes on earnings inside the Roth IRA either. This is a considerable advantage if you would like to help your heirs claim part of their inheritance tax-free.

Roth IRAs are typically easier to withdraw from in times of hardship. Under certain circumstances and conditions, such as if you have lost a job or are buying a first home, you can withdraw some of the funds in a Roth IRA for use in a financial emergency. As a general rule, using your retirement funds to help you through a job loss or other financial disaster should be a last resort, but if your funds need to be used this way, isn't it nice to know you won't also be penalized and more money will be available if you need it?

If you have been saving your retirement funds in a traditional IRA and want to convert to a Roth, you can do this, but you will have to pay taxes on a portion of the investments in the traditional IRA. Because the contributions used to fund your traditional IRA haven't yet been taxed, the U.S. Government isn't going to allow you to make this change without first taxing a portion of the funds in your traditional IRA.

How are the taxes on your IRA calculated? The amount of taxes you will pay depends on your income tax bracket, the amount of money in your conventional IRA now, and how much money you have lost (or gained, if you are lucky) since you began investing in the stock market. The bottom line is, the higher your income, the more taxes you will pay to convert. The best way to determine the tax consequence of a Roth conversion is to consult your tax advisor, or used your tax preparation software to see how the conversion will affect your taxable income.

The good news? You can spread out your 2010 Roth conversion over the 2011 and 2012 tax years, so if you aren't yet close to retirement age, you may be able to avoid moving into a higher tax bracket as a result of the conversion.

If you have a little money set aside for paying these extra taxes, or if in your tax situation, you are planning to receive an income tax refund, paying the taxes on your Roth IRA before it grows is probably a good idea. You will have more flexibility to spend the funds in the IRA how, when, and for whom it is most needed.

Remember, though, if you are unsure, please consult with a qualified professional tax professional or a financial advisor. I am not a tax advisor and every situation is unique.

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