Tax Changes in 2010 – Part 2A – A Primer on Conversion of Regular IRAs to Roth IRAs

• IRON100
• November 20th, 2009

One cannot build an Orion rocket (and some critics of N.A.S.A. say they can't either) without understanding the basis of aerodynamics. So it is with Individual Retirement Account (IRA) conversion. You don't need an engineering degree to understand it either, but you do need to understand the basics of investing at least at the simplest level.

Publication 590  is the IRS document that covers the basic structure of IRAs. There are basically two types of IRAs for people who work but whose spouse may or may not have a company-sponsored retirement savings plan. There is the Traditional IRA, for which contributions may be deductible from one's taxable income, and then there are Roth IRAs, for which the contributions are NON-DEDUCTIBLE from ones taxable income. (For now, I will not discuss SIMPLE IRAs or SEP-IRAs, but may at some point later in this series).

 What is the big kicker for having the Roth IRA? Well, there are two big ones:

1) The distributions at retirement (which can begin at age 59 1/2 for traditional IRA account holders but must begin on April 1 of the year after one becomes 70 1/2 for traditional IRA account holders ) is taxable upon withdrawal at one's marginal tax rate at the time of withdrawal. For Roth IRA holders, distributions are NOT TAXABLE, as long as the Roth IRA has been established for 5 years (known as the 5 year test) and the individual is at least 59 1/2 when the 5 year test is completed.

2) The Roth IRA can continue to be contributed to AFTER age 70 1/2, unlike the traditional IRA, and remainder amounts can remain in the ROTH IRA as long as the contributor is still alive. That can be a huge advantage, particularly if an ROTH IRA contributor continues to work past the age of 70 1/2.

As anyone realizes, tax laws can and will change (particularly in the current "spend-till-you-drop" Congress with massive and seemingly un-survivable deficits), but until something changes, most taxpayers and wage earners need to START their investing by opening a ROTH IRA. Yes, the contributions are NOT tax deductible, but the fact that contributions AND distributions will be tax-free means the opportunity for compounding can be extremely advantageous, particularly if one waits until at least 70 1/2 to make withdrawals. We will get into how big that advantage will be in future blog posts.

By the way, Publication 590 (with link above), was written in 2008 but contains the IRA tax laws for 2009, which still apply today. In 2009, there are income limits that apply to Roth IRA contributors who have a spouse with a company-sponsored retirement plan.

In 2010, some rather monumental changes will allow anyone at any income level, to convert one's Traditional IRA to a Roth IRA. Regardless of one's income level in 2010, one can convert a traditional IRA into a Roth IRA. What is critical in this calculation of whether to make the conversion is:

1) The total amount to be converted (because the amount will be taxed at one's marginal income tax rate). That tax bill can either be paid all in 2011 or spread between 2011 and 2012 tax years.

2) The length of time one will have until retirement (which will affect the amount of time for investment compounding)

3) Some estimate of what the marginal tax rate will be for the retiree once he or she begins to take distributions for the Roth IRA account.

Items 2 is probably the easiest to estimate, Item 1 the second easiest (as one should know by  December 31, 2010 what the next year's marginal tax rate is to determine whether to tax the conversion all within the year of 2011, and item 3 the least easy to estimate, particularly if one has a long time before retirement occurs.

I would like each of you, before I get deep into the numbers for these estimated conversion values, to read Publication 590 to get some sense of how these plans are set up. Make sure, of course, to apply a thick amount of gauze or padding on your forehead in case your head slams against the desk caused by "tax-law-induced-narcolepsy", a serious sleep malady suffered by American taxpayers around quarterly estimated tax deadlines and April 15 of each year.

Despite the risks of this malady, I think it is important to read at least the major points of this document so that you understand the income limits of deductible IRAs. That is particularly true for those over 50 who are trying to make catch up contributions. For those of you who have not set up IRAs at all, you should fully understand the great tax advantages of non-deductible Roth IRAs.

Depending on when I get this information via spreadsheet, I will demonstrate the various outcomes of conversion from Traditional IRA and Roth IRA. If it is delayed, I will start with some simple examples, and then work my way up to more complex examples. If you are good readers and you behave, I may actually post earlier in the week, on Monday or Tuesday. There is at least one other wrinkle that could help the unemployed to make a little additional hay through an IRA conversion from a 401K plan.

One thing is certain, however. One must contact one's tax advisor before making a decision to do the conversion, because your asset situation may be different or complex at retirement time. The purpose of showing these conversions is to allow one to see the variance in outcomes at retirement if tax rates and base investment amounts (before and after taxes) change.

 Hang in there folks, more helpful content is rolling around in the hopper. We are still looking for a few good personal finance writers for DieBrokeBlog. If you think you have what it takes, submit a post to buffalotrader100@gmail.com and it will be reviewed.

Tickers: Conversion of Traditional IRAs to Roth IRAs, Individual Retirement Accounts, Publication 590, Roth IRAs, Traditional IRAs

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