Roth IRA’s have long offered investors a great opportunity to grow their wealth in a tax free environment.  But, because Roth IRA contributions are subject to strict income limitations, not everyone gets to benefit from its features.  Investors with traditional IRA’s have also historically been constrained to income limits when converting their IRA into a Roth.  The good news is, as of January 2010, there will no longer be income limitations on eligibility for converting a traditional IRA to a Roth IRA.  Should you consider this, and if so why?

Background

As a refresher, traditional IRAs are funded with pre-tax dollars and defer taxes on investment gains until the day you withdraw the funds. When funds are withdrawn from the traditional IRA, they are taxed as ordinary income (your highest tax bracket). Conversely, Roth IRAs, are funded with post-tax dollars but all of the investment earnings grow tax free and avoid taxes when they are withdrawn (assuming it’s a qualified distribution).  Roth IRAs can’t be opened by taxpayers
making more than $176,000 (joint returns) and $120,000 for single taxpayers. Furthermore, conversions of traditional retirement funds into Roth IRAs have not been permitted for households with annual incomes above $100,000.

The Conversion Process

A Roth Conversion is a distribution of assets out of a tax-deferred IRA, such as a Traditional or Rollover IRA, which is transferred into a Roth IRA.  If the converted assets are held in the Roth for the five-year holding period, qualified withdrawals are tax-free. The conversion from the traditional IRA into the Roth IRA is considered a taxable event, and the account holder will generally owe taxes on the distribution in the current year. However, in 2010 only, IRA account holders have the option of applying 50% of the conversion amount to the 2011 tax year and 50% to the 2012 tax year, or applying 100% of the conversion amount to the 2010 tax year. Steep investment losses in many retirement accounts may make that tax hit easier to take, and will guarantee that any market rebound in investment values will never be taxed if funds are switched into a Roth account. Finally, conversions must be fully completed by December 31st to qualify for current year
tax treatment.

Why Bother?

So, what makes a Roth IRA so great?  If you believe that your tax rates will be higher in retirement than they are now, Roth IRA’s can save you loads of future taxes—that can translate into greater wealth for you.  
Let’s use the following example.  You are age 40 and have a $200,000 traditional IRA.  Your plan is to retire at 65.  Your current tax bracket is 25% and you anticipate that you will be in (at least) a 30% tax bracket upon retirement.  We suppose that the tax due upon the Roth conversion is $50,000, is paid with funds available outside of the IRA being converted. Let us also assume an investment tax rate of 15% capital gains rate now and in the future.  Using an 8% expected return on your investments, the after tax net return from your Traditional IRA (with tax savings) would be worth $1,186,411, while the after tax net return from your Roth IRA would be $1,369,695.  That’s a difference of $183,284 by converting to the Roth.

Other Considerations
       
It is always wise to check with your tax or financial advisor before making a conversion.  This is particularly true because executing a conversion may actually bump you into a higher tax bracket.  Because converted assets will be considered taxable income, perhaps a partial conversion may be the answer. Converting only a portion of the assets may allow you to stay in a lower tax bracket, allowing you the flexibility to convert additional assets in future years. Ideally, individuals considering a Roth conversion should have the cash on hand to pay the income tax on converted assets. A partial conversion could help limit the conversion taxes to an amount your client can pay without dipping into IRA assets.
      
Does a Conversion Make Sense for You?

Clearly, everyone’s circumstances are unique and there is no one-size-fits-all answer here.  After all, the decision to convert to a Roth can be influenced by a number of factors including:

•        Your age and longevity
•        Your income tax bracket now and in the future
•        Your expected rate of return
•        Your investment tax rate (ie. capital gains rate)

The decision to convert can be complicated.  If you want to learn more, Morningstar, has written an informative overview of the conversion decision, and also provides a useful conversion calculator to help determine if conversion makes sense.   For many, there is no better moment to consider this.  The time is right for a Roth conversion.  

Cathy Pareto, MBA, CFP®, AIF® is the Founder and President of Cathy Pareto & Associates, Inc. For over twelve years, Cathy has been helping financial consumers and professionals understand the world of investments and finance with a sound, but down to earth money management approach. For over a decade Cathy was a Senior Financial Advisor for another Miami based investment advisory firm, where she managed over $200 million in assets for high net worth clients and retirement plans. She has extensive experience in retirement issues, asset allocation, investment selection, investment management, education planning, estate planning coordination, and asset protection strategies. Additionally, she was an Adjunct Professor and Faculty Coordinator for the CFP® Program at Florida International University’s College of Business.

For some of us, retirement may seem a long way off. But consider this: the steps you take now will have an enormous influence on the quality of your life 10, 20, 30 or 40 years from now. Whatever your age, the time to start planning your retirement is now. All it takes is five simple steps.

STEP1: Establish clear, simple, and memorable goals.
Ask yourself, “When do I want to retire?” and “How much money will I need to retire?” Check out our Visual Retirement Planner in our related tools to help you answer these questions.

STEP 2: Put yourself on track to meet your goals.
When you retire, you’ll want to have enough money to enjoy your free time and maintain your current lifestyle. The sooner you start putting money away, the more time it has to grow. Start a monthly transfer from your checking account to your investment account.

STEP 3: Make regular contributions to your company retirement plan.
If your employer offers a 401(k) or 403(b) plan, participate to the maximum. Your contributions are made with tax-deferred dollars so they may reduce your taxable salary, and both contributions and earnings can grow tax-deferred until they’re withdrawn. If your employer matches your contribution, you’re throwing away free money if you don’t participate.

STEP 4: Contribute regularly to an IRA.
If you’re not covered by a company retirement plan, make regular contributions to an IRA. Regardless of the type of IRA you qualify for – Traditional or Roth – your savings will grow tax-deferred. And even if you’re contributing to a plan at work, consider putting some additional money in an IRA. To get on the fast track to retirement, go to our products and services page to view Wells Fargo retirement accounts and the type of IRA that best suits your situation.

STEP 5: Review your goals and track your progress annually.
Read your retirement plan statements and continue to monitor your spending. Are you on target? Remember, you’re involved in a marathon, not a sprint: day-to-day fluctuations in the stock market will have little bearing on your long-term goals.

A rule of thumb
By the time you’re ready to retire, you probably won’t have the same expenses you do now. Some costs will decrease while others will increase. Many financial planning experts estimate that you may need as much as 60% to 80% of your current annual after-tax income to live on through your retirement to maintain your current lifestyle. Think about how you can trim expenses now in order to save more for the future. The sooner you start, the less painful it will be.

Tiffany Bass Bukow is the CEO & Founder of the #1 Personal Finance Website for Women and Families – www.msmoney.com. My life mission is to help people and the world thrive through creating companies that provide money, career and life skills education.

Sometimes it’s hard to stay positive during tumultuous financial times. So, I thought I’d highlight at least a few good things that have resulted from the economic downturn to keep things in perspective:

* Lower gas prices

In a time where already cash strapped consumers are witnessing the evaporation of their retirement accounts and house values, a little relief at the pump will be a welcome change. Gas prices have tumbled from their July highs of $4.11 a gallon down to just under $3 in many U.S. cities, due in large part to shrinking global demand. A happy by-product of this is the negative financial impact it will have on psycho oil-rich dictators like Chavez (Venezuela) and Ahmadinejad (Iran) who are now scrambling to restructure national budget obligations. Sorry boys….looks like the energy orgy is over and it’s time to sober up. I guess this might put a damper on their record of “checkbook diplomacy”, in their efforts to sway leftist or anti-West support in cash poor, vulnerable nations.

*Global warming will slow down

Okay, so I don’t have any scientific evidence to support this claim. But, I figure, if there’s less global demand for oil (and that includes oil guzzling China), then there’s less driving/flying/manufacturing, which means less carbon emissions, which means some slight relief for the ozone layer. Well….at least we can hope, right?

* Responsible bank lending

The days of easy credit are officially over. And while this is bad for some consumers, it’s the responsible thing for banks to do (not only for their balance sheets but for the economy as a whole). If there’s anything that we’ve learned from the sub-prime debacle, is that responsible lending is a critical component for a sound economy. Banks are reverting to their old ways…that is, prudent lending practices that were prevalent before the housing frenzy spiraled out of control. Borrowers will actually have to be credit worthy (gasp!) and will be forced to save for down payments in order to buy a home (gasp, gasp).

*Americans will FINALLY recognize the value in SAVING

It’s no secret, Americans are among the worst savers on the planet and that will come back to bite many of them in the tush right now (and of course in the future). A joint survey conducted by Princeton Survey Research Associates International for the National Foundation for Credit Counseling and MSN Money, found that Americans are largely unprepared for economic hard times–many don’t even have an emergency fund! I suspect that after we all survive this bitter dose of economic reality, many folks will learn their lessons and give serious consideration to saving for unforseen circumstances (like now) and also for their future. Sometimes it’s the negative experiences that teach us the best lessons and serve as a source of discipline and inspiration in later years.

Cathy Pareto, MBA, CFP®, AIF® is the Founder and President of Cathy Pareto & Associates, Inc. For over twelve years, Cathy has been helping financial consumers and professionals understand the world of investments and finance with a sound, but down to earth money management approach. For over a decade Cathy was a Senior Financial Advisor for another Miami based investment advisory firm, where she managed over $200 million in assets for high net worth clients and retirement plans. She has extensive experience in retirement issues, asset allocation, investment selection, investment management, education planning, estate planning coordination, and asset protection strategies. Additionally, she was an Adjunct Professor and Faculty Coordinator for the CFP® Program at Florida International University’s College of Business.