It’s time for confession.
You have one of those old, traditional IRA’s lying around somewhere, don’t you? You haven’t paid much attention to it. There’s probably a year’s worth of unopened account statements sitting on your desk under a pile of other unimportant mail, right? Sure, the balance of the account is nothing to brag about, but your sins likely include an inappropriate asset allocation as well. Highly conservative money market fund, anyone?
Your poor neglected IRA needs some new life. It could use some old-time religion. Heck, your IRA may actually be in need of a good old-fashioned conversion. A Roth conversion, hallelujah!
Believe it or not, the IRS will allow you to transform your traditional IRA by converting it to a Roth IRA. There are restrictions in place (in 2009) that keep most people who make more than $100,000 from taking advantage of the Roth IRA conversion, but in 2010, these restrictions are lifted and all are welcome to convert.
If you are unsure whether or not a Roth IRA is right for you, check out this related post.
Stated simply, the primary benefit of converting to a Roth is that you will never pay tax on the contributions or earnings when you withdraw funds from the Roth account. This assumes that the distribution is deemed “qualified” by the IRS. To learn more about what the IRS considers a qualified distribution from a Roth account, check out this related post.
There is a word of warning, however, that puts a damper on all of this good news regarding Roth IRA conversions. You will be taxed on the entire amount you decide to convert to the Roth IRA. The IRS will treat the conversion as if you received the amount as income in the year of the conversion. It’s as if your employer handed you an extra paycheck for the total converted amount, but you don’t get to spend any of the paycheck today. Yes, it is a bummer, but try to keep a long-term perspective and remember how much you will enjoy receiving all of that money and its earnings (hopefully there will be earnings!) tax-free during retirement when your income tax rate may be higher.
It is important to note here that you do not have to convert the entire amount in your traditional IRA to a Roth IRA all at once. In fact, if you think a conversion might push you into a higher tax bracket, consider employing a number of smaller conversions over several years.
Although I am not a proponent of market timing when it comes to investments, there is a timing strategy you may consider with a Roth IRA conversion. It is usually better to convert after your investments in the traditional IRA have taken a beating. The reason for this should be obvious. The lower your account balance at conversion, the less you will have to pay in taxes on the conversion itself.
The IRS also allows you a “do-over” on a Roth IRA conversion. If you perform the conversion and then later realize, for whatever reason, you miss your old traditional IRA, the IRS allows you “recharacterize” the Roth conversion. It’s as if it never took place. The deadline for recharacterizing your Roth conversion is your normal income tax deadline – April 15 of the year following the year the conversion took place.
So now you know the truth about Roth IRA conversions. And the truth will set you free (from taxes in the future).
