Retirement Savings: Is a Roth IRA conversion right for you?

ira.jpgThe IRA rules around income limitations for converting Traditional IRA money to a Roth IRA have changed. Learn more about the Roth IRA conversion changes and how they might benefit your retirement savings.

When funding your retirement savings, it’s a good idea to diversify, using the various retirement investment options available to you. And now, those with high incomes are able to take advantage of the benefits of a Roth IRA, thanks to changing income rules around converting money from a Traditional IRA to a Roth IRA.

What is the difference between a Traditional IRA and a Roth IRA?

The most basic difference between these two individual retirement accounts has to do with when you pay taxes. With a Traditional IRA, money you contribute may be tax-free while money you withdraw in retirement is taxed. A Roth IRA is the opposite—money you contribute is after tax and money you withdraw in retirement is tax-free. This, along with other differences, can make it valuable to have both of these retirement savings accounts as part of your overall retirement plan.

What’s changing with the Roth IRA conversion rules for 2010?

One of the differences between a Traditional IRA and a Roth IRA has to do with income limitations. High-income earners (modified adjusted gross incomes of over $105,000 for single people and over $167,000 for married filing jointly) cannot make annual contributions to a Roth IRA. While this isn’t changing, these income earners now have the ability to convert money previously contributed to a Traditional IRA into a Roth IRA.

(To determine your modified adjusted gross income, use worksheet 1-1 on page 16 of IRS Publication 590.)

Is a Roth IRA conversion right for you?

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Roth IRA retirement savings accounts offer a number of benefits that you can’t get with a Traditional IRA. With a Roth IRA retirement account, you won’t owe any taxes when you make qualified distributions, you don’t have to begin making withdrawals at a certain age, and you don’t have to take a minimum amount out when you do begin withdrawing funds.

You will, however, have to pay taxes on the amount you convert to a Roth IRA. It’s a good idea to determine how you will pay for any taxes owed before converting your funds; if you can only pay your taxes by withdrawing money from your IRA, you will lose the benefit of tax-free growth on that amount. With the new conversion rules, you do have the option to pay any taxes owed all at once in 2010, or split the amount owed into equal installments through the 2012 tax year.

Also, you should only convert your retirement savings if you plan to keep your Roth IRA account for at least five years before making any withdrawals. Otherwise, you will have to pay a penalty on the amount you withdraw.

When is the best time to do a Roth IRA conversion?

Depending on your circumstances, now may be the best time. Most retirement savings accounts have dipped over the past two years due to the recession. The taxes that are due at conversion could be less than what they would have been simply because you may have fewer dollars to convert. While that likely isn’t a comfort, it is at least an opportunity.

Another consideration is the rising tax rate. If you plan to convert funds from a Traditional IRA, which will be taxed, your tax rate could be higher if you wait a year or two. In 2010, the top federal tax rate will be 35 percent; in 2011, this will increase to 39.6 percent and could go higher.

While Roth IRA retirement savings accounts do offer a number of benefits, it may still not be a right fit for your situation. Before doing a Roth conversion of your IRA, talk with a financial or tax advisor.

This article contains general information. Individual financial situations are unique; please, consult your financial advisor or tax attorney before utilizing any of the information contained in this article.

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Source: PricewaterhouseCoopers, Bankrate.com, Charles Schwab
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