Since Roth IRA’s were initiated in 1998, upper-income individuals have been unable to fully take advantage of the Roth’s ability to earn income tax-free.  2010 provides an opportunity for individuals with incomes over $100,000 to convert their traditional IRA to a Roth IRA.  Of course, the ability to convert brings with it a downside: not only are taxes due on the funds withdrawn from the IRA, the funds are also added to one’s annual income, and can put some into a higher tax bracket. 

Converting a traditional IRA to a Roth is a good idea for many, but the tax hit can be severe.  The tax hit is made worse when one is bumped into a higher tax bracket; why make the conversion if you’re going to pay a huge tax bill as a result?  Wasn’t the whole idea behind setting up and IRA in the first place to take a tax deduction today, when your tax rate is high, and withdraw the funds at retirement, when your tax rate would be lower?

Charitable Giving Offset

One way that individuals can avoid being bumped into a higher tax bracket by converting their traditional IRA to a Roth is through charitable giving.  Gifts can be deducted from income; generally, deductions are allowed up to 30% of Adjusted Gross Income for gifts of appreciable securities; 50% for cash donations.  Any income increase caused by converting traditional IRA funds is offset by the amount of the charitable contribution.

Donations can be made to any charity recognized by the IRS.  For those who need to make a large donation but can’t decide where to donate the money, a charitable gift account can be set up with a donor-advised fund provider.  Contributing to such a fund enables you to receive an immediate tax deduction but take your time deciding which charity gets the money. 

Donations not only benefit the charity, but the donor is able to:

• Convert more IRA funds to a Roth IRA while reducing the tax cost of the conversion
• Benefit from the potential future tax-free growth of a Roth IRA
• Support charitable causes

As with any tax-planning strategy, there could be additional considerations that apply to your particular situation.  Always consult with your tax advisor, so that your over-all personal goals are taken into consideration. 

2010 is the year to act.  Tax laws continue to change, and are once again under review by Congress and the Obama administration.  Those who have been considering making the change to a Roth are advised to consult with their tax advisor soon.

Many investors with traditional IRA’s have been unable to convert to a Roth IRA due to income limits and other restrictions.  However, those limits have been lifted in 2010, so investors who have waited for “just the right time” to convert will be able to do so in 2010.

The Time is Right to Convert

There are three compelling reasons to convert a traditional IRA to a Roth IRA in 2010:

1.  The decline in the stock market in 2007 and 2008 means that earnings on a traditional IRA were lower than normal, and consequently less tax will be due at the time of conversion.

• Taxes are due on a Roth conversion because investors were able to deduct the contributions from their taxable income when they were first deposited. The investor’s tax bill at the time of conversion also depends on several other factors, including their income, their federal tax bracket and their state tax rate.

2.  There is a three-year window on paying the taxes due

3.  Income limits are removed

Proceed Cautiously

Converting to a Roth IRA can be beneficial if it is done correctly and with the help of a financial advisor.  Here are a few areas of concern:

• Pay attention to how conversion taxes are calculated, and be aware of your tax bracket.
• Don’t use IRA funds to pay the conversion taxes.  Money that is converted is exempt from penalties, but money withheld to pay taxes isn’t.
• Whatever money you withdraw from your IRA increases your income, and with the increase in income you may experience an increase in Medicare premiums; you could also affect your Social Security income.

The Benefits of a Roth IRA

There are other benefits to converting your traditional IRA to a Roth IRA, including:

• All withdrawals are tax free if you are at least 59 ½ and your account is at least five years old.
• There are no mandatory minimum distributions.
• There is no age limit on contributions.
• There are qualifying exceptions that allow a withdrawal without paying penalties, including medical and educational expenses, disability, and buying a first home.
• Investors gain more control over how funds are invested by choosing the self-directed option
• IRA funds bypass probate to the direct benefit of heirs.

The decision whether to convert to a Roth IRA is a personal decision, and should be done in consultation with family members and a trusted financial advisor.  There is no “one size fits all” answer to the conversion conundrum.  All factors should be considered, including today’s tax rates, anticipated future tax rates, how the conversion taxes will be paid, the size of our estate, and our overall estate plan.

When it comes to investments, you should always be well versed on the rules and guidelines that come with any investment that you make. It is going to be critical to your success and your ability to maximize your profits to know what you can and can’t do, as well as what you should and shouldn’t do. When you’re working with a Roth IRA, one of the hottest topics is Roth IRA conversion. The rules have always been the same, but they are undergoing a big change in 2010 to allow more people to contribute, convert, and enjoy their retirement savings.

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