Tax deal makes Roth conversions easier to fund

December 13, 2010

The all-but-certain extension of the Bush-era tax cuts has added a sweetener for anyone still considering making a Roth IRA conversion in 2010.

Converting a traditional IRA to a Roth generates an ordinary income tax bill in the year of conversion that can be hefty. However, when Congress removed the income eligibility limit on conversions, lawmakers also gave taxpayers the option to push the tax bill — in equal shares — to 2011 and 2012. It’s a one-time only option available for conversions made in 2010. And, of course, the taxes would have to be paid at the then-prevailing income tax rates.

Of course, pushing the bill out to 2011 and 2012 came with the risk of higher income tax rates — until now. The extension of the Bush-era rates should will make it easier for many retirement investors considering conversion to foot the the tax bill over the next two years.

Should you do a Roth conversion? That depends on whether you think tax rates are going to rise down the road, and your personal tax outlook. For example, it doesn’t make sense to convert now if you’re close to retirement and don’t expect much taxable income after you stop working. In that situation, waiting until after retirement to convert will generate a smaller tax liability.

The best conversion candidates are investors who can fund the tax liability from their taxable assets, don’t expect a significant drop in their effective tax rate in retirement and are converting at younger ages. You’ll also get the best kick from a Roth if you don’t expect to draw heavily from your IRA in retirement and aim to transfer your IRA at death to your beneficiaries.

A final point: The basics of Roth conversion aren’t complicated but they can present some complex choices and tax implications. If you’re going to convert, it’s best to get some expert advice – based on your personal situation – from an accountant or financial adviser.

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