Converting a Traditional IRA to a ROTH IRA

In 2005 congress passed the Tax Increase Prevention and Reconciliation Act of 2005 (known as TIPRA) that set forth some favorable guidelines in converting a traditional IRA to a ROTH IRA.  However, this change was not effective until 2010, which is now right around the corner. 

If you have a traditional IRA, you should strongly consider taking advantage of this for a number of reasons.  The main advantage is that a ROTH IRA can be withdrawn tax free when you are eligible to withdrawal (see ROTH IRA information).  This may not seem like a particularly big advantage, but if you look at the federal deficit right now, it does not seem like taxes will be decreasing in the future, but rather increasing.

One thing to consider when converting a traditional IRA to a ROTH IRA is that you will have to pay taxes on any amount due on the traditional IRA when you convert it (as you had not paid taxes on this money previously).  The good news is that TIPRA also provided that any taxes due on 2010 conversions could be paid one-half each in 2011 and 2012.  Also, if you are like most people, your portfolio has suffered the last few years so your traditional IRA balance is at a somewhat lower level than in previous years, and the tax hit will be less.  This will mean lower taxes now with your conversion and no taxes on your future distributions - a great move on your part.

Another great advantage about a ROTH conversion is that you can always change your mind.  You actually have until October 15 of the following year after the conversion to “unwind” your converted amounts.  For example, let’s say you convert your traditional IRA into a ROTH in early 2010 and the stock market takes another dive.  In this scenario you would have to pay taxes on the converted amount from your traditional IRA on a value that has since become much lower in your ROTH IRA.  You have until October 15, 2011 (actually October 17th in 2011 because October 15 is a Saturday) to recharacterize the converted account back to traditional IRA status.  It’s as though the conversion never happened.

If you are evaluating a traditional IRA to ROTH conversion, it is advisable to discuss this with your accountant or tax preparer to fully understand the tax implications in your situation.  However, it is certainly something to evaluate and could be a great move for your retirement planning!