The rules have changed in the retirement arena, specifically concerning the Roth IRA. As of this year, the $100,000 income restriction has been lifted, so any amount of money can now be converted from a traditional individual retirement account to a Roth IRA. The conversion may make sense for some individuals but could be very problematic for others.
The idea behind the traditional IRA is to provide tax-free growth with the taxes due upon distribution at retirement (at which time the accountholder would presumably be in a lower tax bracket). With a Roth, the accountholder pays taxes on the money before it goes into the account, allowing for tax-free withdrawals in the future.
To determine whether a conversion makes sense, you need to consider the Roth’s guidelines:
1. Taxes: Can you afford to pay the taxes right now? When you convert from a traditional IRA to a Roth, the taxes must be paid before the money can be converted. You shouldn’t pay the taxes with funds from your traditional IRA for two reasons. First, you wouldn’t be able to move as much money into the Roth, providing less opportunity for growth. Second, the money received from the traditional IRA is treated as ordinary income, so unless you’re over 59.5 years old, you’ll incur a penalty if you use these funds to pay the taxes on the account. If you pay the taxes out of pocket, you can either pay the full amount in 2011 or spread it out equally over your 2011 and 2012 tax returns.
2. Early Distribution, the Five-Year Rule, and Other Penalties: You must be at least 59.5 years old to withdraw penalty-free funds from your Roth. There are exceptions to the early-distribution penalty—for example, if you use the money for certain education or medical expenses, or to purchase your first home (check out the full list here). Also, a Roth must be held for at least five years before funds can be withdrawn, no matter how old you are when you convert from a traditional IRA.
3. Tax Brackets: If you think you’ll be in a lower tax bracket when you retire than the one you’re in now, it doesn’t make sense to pay the taxes right now. Also, remember that money withdrawn from the IRA is treated as ordinary income, which is why you must pay taxes when it’s converted. Depending on the amount that is being converted, that extra income could potentially bump you into a higher tax bracket. Being moved into a higher tax bracket not only forces you to pay more taxes, but also affects your ability to obtain college financial aid.
With all of this being said, there are still many valid reasons to convert to the Roth. Unlike the traditional IRA, the Roth does not have required minimum distributions beginning at age 70.5. The Roth can eliminate the taxes that could potentially be passed on to the heirs of a traditional IRA. Finally, the Roth eliminates the fear that taxes may increase in the future, because your tax burden has already been paid.