Dave Sather's Money Matters: Roth IRA conversions even more attractive

Dec. 14, 2010 at 6:14 a.m.

Last week, the president and the Republicans agreed to extend the current income tax rates for another two years.

This move makes a retirement planning strategy that much more attractive.

However, you only have until the end of December to take advantage of this opportunity.

During 2010, no matter what your income is, savers have the opportunity to convert a traditional IRA to a Roth IRA.

Why does this matter?

When withdrawals are made from a traditional IRA, income taxes are owed on the portion that received a tax deduction upon contribution, as well as any gains. The Roth IRA, on the other hand, is tax exempt - meaning that no matter how big the funds grow, you will not owe income taxes on that asset when you go to withdraw from it.

Previously, a major limitation was that only joint income tax filers making less than $100,000 can make this conversion in a normal year.

This year is the one exception. No matter what your income level is, anyone can take advantage of the opportunity to convert a traditional IRA, or an old 401(k), to a Roth.

There are some caveats. Upon conversion, you must pay income taxes on the amount that has not been previously taxed. You can either pay the entire tax obligation with your 2010 taxes or you can split the tax burden and delay it into 2011 and 2012. As such, if you choose to delay the tax burden, you will not have to pay the tax obligation until April 2012 and 2013.

Additionally, it usually does not make sense if you have to take a distribution from the IRA to cover any tax obligations. As such, you will need to set some cash aside to cover this bill.

Until last week, most had surmised that tax rates would be going up and therefore it might be quite a gamble to delay paying the taxes. Now, assuming the president and Congress all follow through, it looks like splitting the recognition of the tax obligation will be a very smart move.

Obviously, the younger you are, the better this strategy will pay off. Someone in their 30s can anticipate decades of tax exempt growth potential going forward.

Even if you are not that young any longer, this conversion strategy can prove wise if you are concerned your future income tax rates will be higher. Although most of us are not too pleased about paying income taxes, it is good to recognize tax rates currently are at some of their lowest levels ever.

As such, converting an IRA or 401(k) to a Roth can effectively work as a hedge against future income tax increases.

Another consideration is that the government forces an individual to begin withdrawals from a traditional IRA about age 70 . For some, this may force more taxes upon a retiree. The Roth IRA, however, has no age 70 distribution requirements. As such, if you want to take money out of a Roth in retirement, you can - but you don't have to. It is up to you.

A final benefit is that if you don't need the Roth IRA assets, your heirs will receive the money income tax free. Therefore, the Roth IRA can provide some multi-generational benefits.

As you can tell, the Roth IRA offers numerous benefits if you are willing to pay some income tax obligations up front.

Spend the time now to consider this strategy because the opportunity to spread out the income tax obligation will end Dec. 31.

Dave Sather is a Victoria certified financial planner and owner of Sather Financial Group. His column, Money Matters, publishes every other Wednesday.



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