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.

Of course, delay could make sense if you expect your account to lose value over the year, since that would reduce the tax bill. (This could be handled by using a recharacterization to convert back to a traditional IRA, so you would not have to pay the conversion tax, a topic for another day.)

Note that converting to a Roth is not the same as investing a lump sum, such as a big bonus, gambling winnings or inheritance. In those cases, many experts recommend spreading the investment over a year or two to avoid the possibility of investing the entire sum at a market peak, then riding down with the subsequent decline.

With a Roth conversion, the only thing that changes is the tax status. Money going into the Roth is not a new investment like an inheritance – it’s already invested. If you worry that your investment is about to fall in value, the solution is to switch to another investment, plan to ride out the downturn, or to put your money on the sidelines as cash.

Although the start of 2010 is not a deadline for doing anything concerning a Roth, there is a deadline at the end of 2010. Investors who convert in 2010 can opt to pay half of the tax bill in 2011 and half in 2012. After 2010, the entire tax bill will be owed for the year the conversion is done.

Use the Roth IRA Conversion Calculator to figure out whether conversion makes sense for you. There’s a good chance the bank, fund company or brokerage that has your traditional IRA or employer plan has a primer on conversions. Wells Fargo (Stock Quote: WFC) has some tips on its site, as does T. Rowe Price (Stock Quote: TROW), Fidelity Investments and American Funds.

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