OCEAN CITY – Since its introduction in 1997, the Roth IRA has enjoyed great popularity — and it’s easy to understand why. If eligible, Roth IRA owners can make after-tax contributions and withdraw them, tax-free, at any time. Rollover or converted contributions can also be withdrawn at any time, although they may be subject to the 10-percent penalty tax. Once the account has been open and funded for five years, distributions will be income tax- and penalty-free if the account holder is at least age 59½ or meets one of the other circumstances for making a qualified distribution. And Roth IRAs are not subject to required minimum distributions during the holder’s lifetime.
One of the Roth’s few drawbacks has been its income restriction for converting from a traditional IRA. Currently anyone, whether married or single, who earns more than $100,000 is not permitted to make a conversion. However, starting in 2010, the IRS is lifting this income restriction. If you’re focused on saving for retirement, this is potentially very welcome news.
“Many people can really benefit from making the switch,” says Laura Grogan-O’Mara, Merrill Lynch Vice President of Legislative and Public Policy. “However, anyone considering converting to a Roth IRA needs to understand the less obvious effects of this decision.”
Grogan-O’Mara cites tax efficiency as “the foremost consideration” in deciding whether to convert to a Roth IRA. Specifically, she views conversion as most beneficial when:
– The balance of the traditional IRA you’re converting is substantial
– You expect to occupy a higher tax bracket in retirement than you do now
– You expect your beneficiaries to move to a higher tax bracket after they inherit your IRA assets
– You can pay the taxes on the conversion from assets other than those being converted
“Under any one of these conditions, it can work to your advantage to pay taxes now and enjoy tax-free withdrawals later,” she says.
If you make that choice, you will owe income tax on the amount you convert. “But it’s not wise to dip into other tax-deferred assets to cover that liability,” Grogan-O’Mara says. “You should plan to use other funds for the payment. How you’re going to meet the liability ought to figure into your assessment of whether this move fits your overall strategy.”
There are two factors you may want to consider as you mull over the choice. One is that recent market turbulence may have primed your IRA for conversion — a lower account balance generates a lower tax burden. The other, notes Grogan-O’Mara, is that “for conversions made in 2010, it’s possible to spread the resulting income over a two-year filing period.”
Another way you can potentially mitigate the taxable burden is by converting only a portion of your IRA assets. However, in considering this strategy, it’s wise to explore the ramifications beforehand.
Because there are so many considerations involved, it’s important to talk with your financial advisor and your tax professional to talk about converting to a Roth IRA.
(A Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-8520.)