The Time May Be Right to Convert Your IRA

Every once in a very long while, your friends in Washington, DC, the “Beltway Boys” do something that helps you. In today’s case study, what they did was leave something alone, which is now a good thing for many of us. Those of us with an individual retirement account, or IRA, can take advantage of a planning opportunity that has never been available to everyone before. It is the chance to convert your traditional IRA to a Roth IRA. So why is that good?

Before we follow the lemmings into the sea, let’s take a look at the traditional IRA, the Roth IRA, and the consequences of converting. Then we’ll make a decision. The traditional IRA was a retirement account that was funded with earnings that were not taxed in the year in which they were earned. Individuals were supposed to leave that money alone until they were at least 59 1/2, when they could start to take it out and use it to help fund their retirement years.

Individuals were required to withdraw money after age 70 1/2, and any money that was withdrawn was to be taxed in the year in which it was taken out. In theory, the income tax rate in retirement was supposed to be lower than during the working years because people were going to earn a lot less money.

Several years ago, along came Senator Roth with a variation on that theme. His idea was to stimulate Americans to increase their rates of saving, so his plan allowed after-tax money to be put into a Roth IRA, which would grow tax-free and come out tax-free. The catch was that there was an income limit on people who could do this, so that wealthy folks were prevented from taking advantage of these plans.

Then in 2006, the Beltway Boys got a whiff of the trillions of dollars of untaxed money that we Americans had dutifully squirreled away in our traditional IRAs over the years and came up with a plan to tax it. They allowed some people to convert their traditional IRAs to Roth IRAs, but with the condition that it be taxed now. Again, they restricted the people who could convert to those with incomes below $100,000. But hidden within that law was a lifting of the income restriction in 2010 and an opportunity to spread the income tax over two years, 2011 and 2012.

As you know, the Beltway Boys never got around to closing this loophole last year because they were focused on fouling up something else, so this planning opportunity slid through and is just lying there for you to pick up. But like anything else with income tax implications, you need to do some homework before you just flip the conversion switch. You will need to pull out your IRA statement from the end of 2009, go online and search ‘Roth IRA Conversion’ or ask your financial advisor to help you with the calculations.

There will be tax due on the money in your traditional IRA when you convert it, but you can either pay all of it with your 2010 tax return next spring, or spread it over your 2011 and 2012 returns. You will want to pay the income tax from money set aside in savings, not from money in your IRA. The risk for you is twofold: one is that you do not have enough money in your savings account to pay the income tax and two is that income tax rates may be raised in 2011 and 2012, causing you to pay more taxes than you planned. This is where planning first can really prepare you to make this decision.

There are some experts who believe that income tax rates will be raised soon, thereby reducing the benefits of converting. Someone smarter that I am can help you figure out the consequences of converting if your income tax rate goes from 25 percent to 33 percent. That is something that the conversion calculators on the Internet will do for you if you choose to do this analysis yourself.

In conclusion, these planning opportunities do not come along very often, so consult your income tax advisor, your investment advisor or your friendly, neighborhood attorney and get your information straight before you make your decision. Good planning prevents bad surprises.

Christopher M. Abernethy has been practicing law in Hampton Township since 1976. He focuses on elder law, which includes wills, trusts, powers of attorney, living wills and probate matters. He also is proficient in all aspects of real estate law and business law. He is a member of the National Association of Elder Law Attorneys and the AARP Legal Services Network. He can be reached at 412-486-6624 or by email at cabernethy@aaylaw.com.