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Roth IRA Conversion Rule Changes Offer Opportunity

Why would you volunteer to pay income tax this year by converting a traditional IRA to a Roth IRA? If you leave things alone, you won’t owe any current tax on the assets in your account, regardless of their investment performance. But the promise of a future tax payoff—combined with the prevailing economic conditions—may warrant this unusual approach. And thanks to a 2006 tax law change, a conversion to a Roth in 2010 is a possibility for all investors, regardless of income.

With a traditional IRA, contributions may be tax deductible, but the amount you deduct and subsequent earnings will be fully taxed as income when withdrawn during retirement. (The same rules apply to IRAs holding assets rolled over from traditional 401(k)s or other employer-sponsored plans.) And you generally must begin taking those taxable distributions during the year after the year in which you turn age 70½.

In contrast, contributions to a Roth IRA are never deductible, but qualified distributions from a Roth that has been established for at least five years are completely tax free. And because the government won’t benefit when you take distributions, it doesn’t require you to take them.

Until now, the catch has been that high-income individuals can’t contribute to a Roth IRA, and converting a traditional IRA to a Roth hasn’t been allowed if your adjusted gross income exceeds $100,000. The latter rule changed in 2010, when the income cap for conversions was eliminated. And though a conversion to a Roth requires you to pay income tax on the amount you convert, if you make the conversion in 2010, you’re allowed to spread out your tax payment over 2011 and 2012.

Choosing between saving for retirement with a traditional IRA or a Roth is in part a question of whether it’s better to pay the IRS sooner or later. Being taxed on current contributions to a Roth IRA or on a conversion from a traditional IRA takes money out of your pocket now, but you may do better later, either enjoying tax-free distributions or passing along the account to your heirs, whose withdrawals also won’t be taxed. But the law permitting anyone to convert to a Roth, coupled with the bear market’s depressed asset values, adds interesting twists to this debate. Consider these four reasons it may pay to convert.

1. You’ll pay less to convert an IRA whose value has plummeted. Rare is the investor who hasn’t seen retirement account values fall by at least 25% during the bear market. As painful as that has been, however, it can be an advantage if you choose to convert to a Roth IRA in 2010. You’ll be taxed on the value of the account at the time of the conversion, regardless of what it may have been worth a few years earlier. Suppose the assets in your IRA were worth $500,000 two years ago, but in 2010, they are worth only $400,000. At the top current income tax rate of 35%, that saves you $35,000.

2. You’ll avoid a higher tax bill later if rates rise. With individual tax rates at near-record lows and tax revenue falling far short of federal budget commitments, tax rates are likely to go up in the near future. It may be better to take your lumps under current tax law—even if all or part of the conversion is taxed at the top rate of 35%—than to risk losing much more of your investment to the IRS later.

3. Converting to a Roth IRA gives you maximum flexibility on distributions. There’s not much give in the rules on withdrawals from traditional IRAs and 401(k)s. Beginning the year after the year you reach 70½, you’ll face minimum annual distributions designed to use up the account during your expected life span—and you’ll pay a 50% penalty on any shortfall from the required amount. With a Roth, you can take as large or small a distribution as you choose each year, and you have the option of leaving the account intact to provide tax-free income to your heirs.

4. A partial conversion to a Roth lets you customize your tax liability and benefits. A Roth IRA conversion needn’t be an all-or-nothing proposition. You can convert as much or as little as you want each year (although the option of stretching out tax payments applies only to conversions in 2010). Making a partial conversion lets you limit current payments to the IRS while also providing some tax-free income during retirement.

We can help you decide whether a conversion makes sense in terms of your unique situation and overall financial goals.


This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.

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