Converting a Traditional IRA to a Roth IRA: Why Now?

Beginning in 2010, the IRS is allowing everyone to convert a traditional IRA to a Roth IRA. (Refer to previous post to learn more about the IRA Basics.) Prior to 2010, only taxpayers with a modified adjusted gross income (MAGI) that was not more than $100K could make the conversion. The main reason to make the conversion is to gain the tax advantages of a Roth IRA, which is tax-free growth and tax-free distributions. The catch to making the conversion is that the IRS requires you to pay tax on the amount you pull out of the traditional IRA that would have been taxed had it been taken out as a normal distribution from the IRA account. That means that the growth or earnings in your traditional IRA account is included in gross income for the year in which you convert it to a Roth IRA. For 2010 only, the IRS is allowing that amount to be split evenly and included in your 2011and 2012 gross income. The benefit here is that you can spread out the taxes you have to pay for the conversion over 2 years rather than only in the year of the conversion. Even with the IRS allowing you to soften the tax blow when converting to a Roth IRA this year, make sure that you have the money to be able to pay these taxes before deciding to make the conversion. The bottom line is that you pay the taxes now rather than later.

There are also estate tax impacts to converting a traditional IRA to a Roth IRA. If your estate is large enough to incur estate taxes, both traditional IRA and Roth IRA assets will be taxed at the estate tax rate. Once the beneficiary has received the assets, distributions from IRA accounts are still taxed according to their taxable nature. In other words, distributions from a traditional IRA are taxed and distributions from a Roth IRA are tax-free. This results in double-taxation of the traditional IRA. Yet another benefit to a Roth IRA. If you have the cash to pay the tax on the IRA conversion, your beneficiaries may thank you for making that conversion. The bottom line here is that you pay the taxes now rather than your beneficiaries paying the tax later.