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Roth 2010 Conversion –
The Financial Planning Opportunity
of a Lifetime

By Brett Danko, CFP^®

Yes, you read the headline correctly. Just in case it didn’t sink in – here it is again:

The Roth 2010 Conversion is
THE Financial Planning Opportunity of a Lifetime

While this may not apply to everyone, it does apply to most people.

Here are the basics (I apologize for the dry nature and length of this information, but hang in there – it’s worth it). As is the case with most things in life, this is complex and we are simply hitting the high points here. Please note we are NOT discussing the $5,000 yearly contributions to a Roth account.

If you have questions or do NOT understand any of the information, please contact us at Main Street Financial Solutions, LLC. Here goes:

What is a traditional IRA?

A traditional IRA or a rollover IRA (from a previous job) is comprised of PRE-TAX money. This means that when you withdraw the money, your contributions AND future earnings on those contributions are all taxable.

Also, you MUST start taking distributions at age 70½ (called required minimum distributions or RMDs). Therefore, even if you do not need the money, the IRS says you must take minimum distributions AND pay tax on them.

What is a Roth IRA?

A Roth IRA is AFTER-TAX money which means you have paid taxes already on the amount contributed.

How is this better?

Well, it allows the Roth IRA to grow tax-deferred and ALL qualified distributions are TAX FREE.

While numerous things can make the earnings qualified, to simplify, just remember the earnings become qualified after having the Roth open for 5 years and after age 59 ½.

Also, there are NO required minimum distributions at age 70 ½.

What is so special about 2010 with regards to the Roth Conversion?

Currently, if your income is above $100,000 you can NOT convert to a Roth IRA. However, in 2010, the income limitation goes away so every taxpayer is eligible to convert, no matter how much money they make. This will allow many taxpayers the opportunity to convert for the first time.

So how do I convert – what are the basics?

When you convert, you must pay income tax on the amount converted.

This money should come from a taxable account (NOT from IRA or 401(k) money or another tax deferred account which would defeat the purpose). This is a crucial point. You want to pay taxes with money held in taxable accounts so that the full amount of your existing IRA is converted into the Roth IRA and grows tax deferred. Once again, all qualified distributions in the future will be tax free.

This tax free status applies to your heirs as well. If your children, grandchildren, etc. inherit this Roth IRA account, they will receive TAX-FREE distributions from it until the Roth IRA runs out of money or they die.

Why should I convert IF I lose access to the money I pay to the IRS forever?

Yes, you do lose access to the money paid to the IRS from a taxable account (this is something the academics call “opportunity cost”). However, you are making the bet that in the future the account will be much higher and you will NOT have to pay income tax on the future accumulation.

Here is a simple example:

If you earned 6% inside your Roth IRA for 20 years, a $100,000 investment would be worth approximately $320,714. The entire amount, including the qualified earnings would come out tax free to you OR your heirs.

By contrast, if you earned 6% in a taxable account and were subject to 25% federal, state and local taxes (meaning a net return of 4.5%), you would have only $241,171 - a difference of nearly $80,000 in JUST 20 years.

If your average rate of return is higher and/or you have a longer time period, the number grows exponentially.

For example, those same numbers ($100,000 and a 25% tax rate) run using 8% returns over 35 years are $1,478,534 for the Roth and $768,609 for the taxable account. This creates a nearly $710,000 difference over 35 years. WOW!!!

And yes, the entire amount in the Roth ($320,000 & $1,478,534 in the prior examples) comes out TAX FREE if open at least 5 years and you are over 59½ . WOW (again)!!!!!!

When do I have to pay the tax?

For 2010 only, you are allowed to pay ½ of the tax when you file your 2011 taxes (by 4/15/2012 or 10/15/2012 with extensions) and the other ½ is due when you file your 2012 taxes (by 4/15/2013 or 10/15/2013 with extensions). This is a tremendous advantage and allows you time to generate cash to pay for the taxes over a number of years).

Do I have to convert my entire traditional or rollover IRA?

Absolutely NOT. You convert just the amount that makes sense for your tax and cash flow position.

What happens if I convert 1/1/10 and my account value is LOWER by 7/1/2010 or 3/1/2011?

This is even better! You just “re-characterize” the account by the following tax year (by 4/15/2011 or 10/15/2011 with extensions). It is as if you did no conversation at all or “get out of jail free card” if you wish.

If I re-characterize because the account value went down, when can I “re-convert” to take advantage of that lower account balance?

You can re-convert within 30 days of your re-characterization or wait until the next calendar year. (Yes, this may sound confusing but it really isn’t.)

When would I NOT convert to a Roth IRA in 2010?

1. If you plan on accessing the money in the Roth IRA account within 10-12 years, it may not make sense to convert since not enough time would elapse to justify paying the taxes now. You need time (more than 10-12 years) to make this strategy work.
   
   
2. If you do NOT have the cash to pay the taxes. Although as we show above, you have a number of years to pay the tax if you convert in 2010. In future years 100% of the tax is due by the filing of your taxes for that year. For example, if you convert in 2011, you owe the entire amount by 4/15/2012 or 10/15/2012 with extensions.
   
   
3. You do NOT have any traditional or rollover IRAs. This can be the case if you have all your money in your current employer’s retirement plan. However, depending on your age and plan provisions, you may be able to do an “in-service withdrawal” and then convert to the Roth IRA.
   
   
4. If your income is below $100,000, you may be able to convert right now.

You may be asking yourself – should I do this???

The answer to that question is based on your personal circumstances and can be complex. Please contact Main Street Financial Solutions, LLC or your financial advisor to discuss.

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