Roth Rules for Retirees: Convert Early

Many investors are focusing on Jan. 1, 2010 as the key date for Roth conversions. Just in case anyone’s not clear about this, that’s the start date, not a deadline.

Starting on Jan. 1, anyone can convert a traditional IRA, 401(k) or similar plan into a Roth IRA. Prior to that date, only taxpayers with modified adjusted gross incomes of $100,000 or less are permitted to convert to Roths, which, unlike other retirement plans, allow tax-free withdrawals in retirement.

In other words, you can convert anytime after Dec. 31 – whether that's 2010, 2011 or any other year.

Still, many investors who feel that conversion makes sense for them would be wise to get to it sooner rather than later.

The main reason is that the sooner your money is moved into a Roth, the sooner you will begin tax-free compounding. If you delay, your tax bill could get bigger as your traditional IRA or employer plan grows.

Many investors’ traditional IRAs and employer-sponsored plans have lost money during the past couple of years, despite the stock market’s rebound since March. The smaller the account, the less tax you’ll have to pay after the conversion. Waiting until the end of 2010 would mean giving your account another 12 months to recover, possibly increasing the tax bill.

An investor who converted a $100,000 IRA, composed entirely of deductible contributions and earnings, would have to pay $25,000 in federal income tax, assuming a 25% tax bracket. If the market took off, raising the account to $120,000, the bill would be $30,000.

To make a conversion worthwhile, the investor must convert the full amount and pay the taxes from some other source. So, in this case, a delay would force the investor to come up with another $5,000.