With only a few weeks remaining, a lot of people are rushing to perform a Roth IRA conversion in 2010. The last day for Roth IRA conversions in 2010 is December 31. Unlike traditional and Roth IRA contributions (which can be completed all the way up to April 15 for the previous tax year), conversions must be completed by 12/31.
Why are Roth IRAs in the news so much this year? Previously, Roth IRA conversions were limited to people who earned below a certain income limit ($100,000). A change in the tax code, effective as of January 2010, removes the income limit which means more people are allowed to to convert from traditional IRAs to Roth IRAs.
In addition to the income limitation being removed, the IRS is allowing people who convert in 2010 to spread their taxes out over two years. So instead of having to pay it all on your 2010 tax return, you can pay half in 2011 and half in 2012.
This may appear to be a no-brainer for people to convert, but don't leap before you look. Just because the income limit has been lifted and the taxes can be spread out over two years doesn't mean you should rush to convert in 2010.
Before you make a decision on whether to convert or not, here are some basics about traditional and Roth IRAs you should be aware of:
Traditional IRAs
- Money put into traditional IRAs is tax deductible (income limits apply if you are covered by an employer sponsored retirement plan)
- Money taken out of traditional IRAs is taxed at your regular income tax rate, so whatever tax bracket you fall into (15%, 28%, etc.) is the rate you will pay on IRA distributions.
- Distributions must be taken from traditional IRAs once you reach age 70 1/2.
Roth IRAs
- Contributions to a Roth IRA are not tax deductible.
- Your ability to contribute to an IRA may be limited if your income is high.
- Qualified withdrawals (must be at least age 59 1/2 and have had the Roth for at least five years) are not subject to income tax.
- Unlike traditional IRAs, you are not required to take money out of your Roth IRA once you reach age 70 1/2/
As you can see, there are benefits and drawbacks to both types of IRAs, so how do you know which one is right for you? Here are some general guidelines to help you determine whether a traditional or Roth IRA makes the most sense for you:
- Roth IRAs are more beneficial if you expect to be in a higher tax bracket when you retire (or when you'll need the money).
- Traditional IRAs make more sense if you expect to be in a lower tax bracket when you retire, since you'll get the tax break when you make contributions (when you are in a higher tax bracket).
Should You Convert?
Please note that when you do a Roth IRA conversion you must pay taxes on the entire amount converted. This is because Roth IRAs are tax-free when you take withdrawals (hey, you gotta pay tax sometime). As a result, your taxes could go up considerably in the year you convert, depending on your other income, how much you convert, and what tax bracket you are in. This can be a substantial tax bill depending on how much you convert and what tax bracket you are in.
Even with the higher taxes that usually result from converting to a Roth IRA, it's still a good strategy for some people. A Roth IRA conversion may be beneficial to you if: You should consider converting to a Roth IRA if:
- You expect to be in the same or higher tax bracket when you retire (or when you will need the funds),
- You have a long time horizon for the funds that will be converted, and
- You have funds outside of the IRA to pay the tax resulting from the conversion.
The new Roth IRA conversion rules will benefit a lot of people who didn't have access to Roths previously; however, Roths may not be right for everyone. People who weren't able to invest in Roth IRAs previously, or people who expect to be in a higher tax bracket when they retire will benefit the most from a Roth IRA conversion.
The bottom line is that just because you can convert to a Roth doesn't mean you should convert. Every person's situation is different, so you should evaluate your unique situation to determine if a Roth IRA conversion is right for you. Furthermore, you should evaluate your situation every year as tax rules change each year. A Roth conversion in 2010 might not make sense for you, but a conversion in future years could make sense if tax laws change or your situation changes.
The year 2010 brought many new tax and investing planning opportunities using Roth IRAs. Learn how to get the most out of your Roth IRA, including the Roth IRA max you can contribute, the advantages of doing a Roth IRA conversion in 2010, how and when you can do Roth IRA withdrawals and much more at http://www.rothirarulesandguidelines.com
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