Roth IRA

Joe,

One of my friends just asked me if I planned on converting my IRA to a Roth IRA. He was excited because of a rule change that now made him eligible. He asked me if I were going to do the same thing. I lied and said I was. To be honest, I don’t even know the difference. Should I convert my IRA? What is the rule change he is talking about?

Walter, Stillwater

 Walter,

You are not alone in not knowing the difference between a traditional IRA and a Roth IRA. The basic difference rests when the taxes come out. With a traditional IRA you put money in tax free, but are then taxed when you withdraw. With a Roth IRA, you pay an upfront tax on the investment, but then the money is tax-free to withdraw.

My guess is the change he is talking about is the dropping of the income limit for those who can open or convert a Roth IRA. In the past, only investors with a yearly income under S100,000 could access a Roth IRA. A recent study by Fidelity Investments found that 83% of those surveyed knew nothing about the removal of income limits on IRAs. Understandable given that most investors face other financial issues to worry about. Which is a shame because investor ignorance clouds a significant economic opportunity.

So should you convert your traditional IRA to a Roth IRA? Probably. The most obvious reason is the tax-free income stream. With a Roth IRA, an investor pays the upfront tax, based on his income tax percentage, on the contribution. This strategy works especially well for those who plan on being in a higher income bracket upon retirement than they are now. Not just those starting out, but those who are out of work right now.

But even if you are doing well financially a Roth conversion is advisable. In a one time offer, the government will allow investors to defer the tax hit over two years. If you convert your traditional IRA to a Roth IRA in 2010, you can spread the tax liability evenly over 2011 and 2012. This helps to lessen the shock of a one time large tax hit.

 Another reason to convert now is to take advantage of a shrunken portfolio. Yes, there is an upside to the freefall of your IRA. When you convert to a Roth IRA, you are taxed on the amount converted. If your IRA has a value reduction of 30%, that means 30% less in taxes. When the account grows, you will not be taxed on the additional growth.

Finally, a conversion to a Roth IRA provides you more control over your estate planning. There are no mandatory deductions at 70.5, meaning a Roth IRA is preferable if you plan to pass on the account to beneficiaries.

All of these factors contribute to the proverbial perfect storm for you to convert your traditional IRAs to a Roth IRA. Don’t let your ignorance or a lack of press contribute to a missed financial opportunity.

Hope this information helps. Maybe you can even give your friend some advice. As always, check with a money manager whom you trust before making any conversions. There are many subtle rules that impact your conversion. Best of luck, Walter.

photo credit: scottwills

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