2010 Roth IRA Conversion – Opportunity or Hazard?

By Jon Flynn

This year, in 2010, you’ll probably hear a lot of buzz regarding whether or not you should convert your Traditional IRA or 401K to a Roth IRA. 

What is this all about?  Well, before this year, only those with adjusted gross income below $100,000 (married or single) could convert a Traditional IRA or 401K to a Roth IRA.  In 2010, that limitation goes away for good allowing anybody to convert (unless congress chooses someday to change it back).  A second but just as important feature is that the IRS is allowing those that convert in the year 2010 (and only in the year 2010) a special tax break.  Which is, for those who convert this year, the IRS will allow you to spread the tax bill over two years.  How it works is that you’ll include half of the total value of the conversion on your 2011 tax return and the remainder on your 2012 return.

Sound good right? But before you convert, do you homework.  Because what might be a future tax savings opportunity for some people, can create a financial hazard for others.  Let’s take a look…..

 Some potential opportunities of converting may be:

1.      If you’re younger, tax savings can add up over many years by converting now.  This is because you’ll be paying taxes on whatever your IRA balance is now versus paying taxes on whatever the value will be in the future.  For example an IRA that is worth say $25,000 today could be worth approximately ten times that amount in 30 years at a compounded rate of 8% (this rate is used for illustrative purposes only).  Would you rather pay taxes on $25,000 or $250,000?. 

2.      Unlike Traditional IRA’s, Roth Ira’s don’t require that you take a required minimum distribution at age 70 ½. 

3.      If you’re lucky enough in retirement to where you don’t need your Roth IRA savings, it can be easily gifted to children because the tax has already been paid when you converted many years earlier.

Some potential hazards of converting may be:

1.      If you are older, there may not be enough time for you to realize any long term tax savings by converting.  Especially if you plan on using your IRA to supplement your income when you retire.  However, for those that are older but may not need their IRA savings in retirement, it still might make sense to convert.  This is because the money in your Roth would really be earmarked for the next generation, which has a longer time horizon to realize the tax savings on an inherited Roth IRA.

2.      When you convert, you’ll have to show on your tax return the conversion amounts as additional income.  By doing this you’ll be increasing your adjusted gross income.  As a result you might end up having to pay higher Medicare premiums or even having your Social Security payments taxed.

3.      For parents, household income is usually the biggest factor in determining Financial Aid eligibility for a college bound child.  When you convert, you increase your income, thus putting Financial Aid at risk.

Everybody situation is different and arriving at solutions can get complicated.  So always consult with financial, legal, and tax professionals before making any decisions.

Jon Flynn is a Certified Financial Planner ^TM and owner of Flynn Financial in Eynon. He is a Representative of Securities America, Inc., Member FINRA/SIPC and of Securities America Advisors, Inc. Flynn Financial and Securities America are unaffiliated.   Mr. Flynn can be reached at 570-876-5000.