Roth IRA Conversions: Coming in 2010!

Next year, anyone may convert a traditional IRA to a Roth IRA. No income limits will stand in the way of the conversion.

Why it might be a good idea
A Roth IRA permits tax-free growth and tax-free income distributions in retirement (assuming you are age 59½ or older and have held your Roth account for 5 years or longer). You can contribute to a Roth IRA after age 70½, without having to take mandatory withdrawals. While contributions to a Roth IRA aren’t tax-deductible, the younger you are, the more attractive a Roth IRA may seem.
However, older investors have reason to go Roth as well – especially if they don’t really need to withdraw IRA assets or would plan to reallocate their IRA holdings towards fixed income investments and other tax inefficient tools (e.g. Mortgage Backed Bonds, High Yield Funds, Hedge Funds). Roth IRAs are particularly well-suited to fixed income investments, as the consequences of potentially lower returns are ameliorated by the low taxation of those returns, either when the funds are earned or withdrawn.
Also, under present tax law, converting an untapped traditional IRA to a Roth will shrink the size of your taxable estate, and careful estate planning could foster many years of tax-free growth for those assets.
Currently, if you pass your Roth IRA to your spouse when you die, they can treat the inherited IRA as his or her own and forego withdrawals. So those Roth IRA assets can keep compounding untaxed across the rest of their life.
If your spouse then names a son or daughter as a beneficiary, that heir has the choice to make minimum withdrawals according to his or her life expectancy, all while the assets continue to compound tax-free. Currently, withdrawals from an inherited Roth IRA are not subject to income tax.

Why it might not be a good idea
The IRS regards a traditional IRA-to-Roth IRA conversion as a distribution from a traditional IRA – a taxable event. You’ll need to pay taxes on the entire amount of the conversion.
But, with the recent carnage in the markets, many IRA values are (hopefully) at a very low point. That translates to paying less tax on eventual gains. In addition, there’s strong reason to believe that income tax rates will increase in the coming years – another reason why now may be a good time to convert. (Another alternative is to do a partial Roth IRA conversion if converting the full amount would send you into a higher tax bracket.)
Using IRA assets to pay the conversion tax isn’t advisable. If you’re younger than 59½, you’re looking at a 10% penalty on the amount you withdraw, and you’ll lose the chance for tax-free compounding of those assets within the Roth IRA. What this means is that you should generally be comfortable with spending funds out of a taxable account.

Why you might want to fund a Roth IRA this year
In 2009, any withdrawals from a traditional IRA can be used to fund a Roth IRA. In years past, mandatory withdrawals from a traditional IRA typically couldn’t be deposited into a Roth IRA. But the federal government has suspended mandatory IRA withdrawals for 2009. Any IRA withdrawals made in 2009 are thereby elective withdrawals. So, if your adjusted gross income (AGI) is $100,000 or less, you have an option to fund a Roth IRA with a withdrawal from a traditional IRA – at least through the end of 2009.
In 2009, you can fund a Roth IRA with after-tax contributions to a 401(k), 403(b) or 457 retirement savings plan. This year, you can take those contributions and convert them to a Roth IRA tax-free, provided your AGI is $100,000 or less. Additionally, there is no limit to the conversion amount.

A potential tax break for those who convert in 2010
If you do a Roth conversion during 2010, you can choose to divide the taxes on the conversion between your 2011 and 2012 federal returns.
Be sure to consult your tax advisor and financial advisor before you proceed. (This is definitely a team effort, as the issue of expected returns is a major factor in the analysis.) In fact, you should generally consult your advisors before you arrange any rollover, trustee-to-trustee transfer, or same-trustee transfer of your IRA assets. In any year, you should fully understand the potential tax impact of a Roth conversion on your finances and your estate. Also, remember that while the income limit on Roth IRA conversions will go away in 2010, the income limits on Roth IRA contributions still apply next year and for the foreseeable future.