First, let's lay down some basic framework for both types of IRAs. Both traditional and Roth IRAs allow the same maximum contribution for 2009: $5,000 plus a $1,000 catch-up contribution if you are over the age of 50. With a traditional IRA, your contributions are paid with tax deferred (before tax) earnings whereas Roth IRA contributions are made after tax. The investments in both accounts grow tax free (provided you don't break their rules), but when you become eligible for withdrawals at age 59 ½, the withdrawals from the traditional IRA are taxed at your ordinary income tax rate verses no taxes on the Roth. In addition, the Roth IRA doesn't have the required minimum distribution (RMD) when you reach age 70 ½.
When making a choice between the two IRAs, most people would choose the Roth and pay the taxes on their contributions at today's income tax rate rather than at an unknown future tax rate, and avoid the mandatory distributions. Unfortunately, IRS restrictions on who can contribute to a Roth IRA have left out those with modified adjusted gross incomes (AGI) above $105,000 for individuals and $166,000 for married couples. In 2009, for converting your traditional IRA into a Roth IRA, the modified AGI limit for both individuals and married couples is $100,000.
The Great Conversion Opportunity
In 2010 only, the income limits are removed on converting your traditional IRA into a Roth. All Roth conversions require you to pay income tax on the conversion amount; however, those who do the conversion in 2010 can defer the resulting taxable income for the next two years, 2011 and 2012.
This conversion window could provide a compelling opportunity for individuals and families with high income and lower IRA balances from the market. For example, the Smiths earn $140,000 a year and have a traditional IRA that has dropped in value from $100,000 down to $60,000. The Smiths can have taxable income up to $208,850 and still remain in the 28 percent tax bracket. Therefore, converting the entire IRA won't put them in a higher tax bracket, and they can defer the taxable income equally in 2011 and 2012.
Recharacterize Your Losers
Suppose in 2008, you converted your $100,000 IRA to a Roth at a 28 percent marginal tax bracket. The Roth account suffered significant losses and is only worth $60,000 today, but you are facing a tax bill of $28,000 on the conversion. If you recharacterize, or undo the conversion by transferring the funds back to an IRA, the Roth back to a traditional IRA by October 15, 2009, the tax bill goes away. If you want to recharacterize, you must act now and follow some specific rules. Contact your custodian and get the requirements.
For high-income, high tax-bracket clients, partial conversions may offer some attractive benefits in 2010. For example, the Baker's are in a 40 percent marginal tax bracket and want to convert an entire $400,000 IRA in 2010. The Bakers aren't too thrilled with the resulting $160,000 tax bill. Even splitting the tax bill so they pay $80,000 in 2011 and $80,000 in 2012 isn't very palatable.
This is where segregating the Roth IRA accounts comes into play. If the Bakers' traditional IRA holds four mutual funds valued at $100,000 each, creating four separate Roth accounts will allow them to choose which ones, if any, to recharacterize if future losses occur. So, if one account grows from $100,000 to $150,000, and the other three lose value, the Bakers will keep the winner and recharacterize the losers. The Bakers would pay just the $40,000 in income tax on the one conversion and file a tax extension until October 15, 2011.
I've covered some issues that are otherwise very detailed and have some cumbersome restrictions and tax consequences. Consulting with your CPA is essential when considering a conversion or a recharacterization of your IRA.
Andrew Brown is a Certified Financial PlannerTM and a Fee-Only Registered Investment Advisor.