Roth IRA Conversion Rule Changes

Beginning January 1, 2010, conversions from a traditional IRA to a Roth IRA will become available to all individuals, regardless of their incomes.

Under pre-2010 law, the opportunity to convert a traditional individual retirement account (IRA) into a Roth IRA was limited to individuals whose adjusted gross income is less than $100,000. Beginning January 1, 2010, conversions from a traditional IRA to a Roth IRA will become available to all individuals, regardless of their incomes. This opportunity creates a dilemma for high income owners of traditional IRAs: do the benefits of allowing the assets of a Roth IRA to grow tax-free for a longer period of time outweigh the acceleration of income tax triggered by the conversion of a traditional IRA to a Roth IRA? The answer requires a close review of each individual's objectives and circumstances.

Traditional IRA vs. Roth IRA

To understand the quandary that this change to the tax law presents to high income individuals, it is first necessary to compare the features of a traditional IRA and a Roth IRA. Distributions from a traditional IRA are taxed at ordinary income tax rates. In contrast, qualified distributions from a Roth IRA are not subject to any income tax because contributions to a Roth IRA are made with after-tax dollars.

The distribution requirements for a traditional IRA also differ from a Roth IRA. For a traditional IRA, the owner must begin receiving minimum required distributions (MRDs) in the year after the owner turns 70 1/2. The MRD rules, however, do not apply to Roth IRAs during the original owner's lifetime. Therefore, if an individual does not need distributions from his or her Roth IRA, the assets in the Roth IRA can continue to grow tax-free for a longer period of time than a traditional IRA. Depending on the time horizon and investment returns, this additional growth in a Roth IRA can be substantial.

Conversions

Beginning in 2010, individual owners of traditional IRAs can convert their accounts into Roth IRAs, regardless of their level of income. In addition, certain eligible rollover distributions from employer sponsored retirement plans, including 401(k) plans, can be rolled over directly into a Roth IRA. To determine whether a conversion from a 401(k) plan would be permitted, the terms of the retirement plan would need to be reviewed, as many plans prohibit such distributions prior to the employee's separation from service.

Upon conversion from traditional to Roth, the...

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