Your Nest Egg Source: sxc.hu Photo: Patrick-:L

Your Nest Egg Source: sxc.hu Photo: Patrick-L

As you know, this year is a magical year for the Roth IRA retirement account. It is possible to convert your traditional IRA into a Roth IRA, no matter your income. For this one year, 2010, anyone can convert a “regular” IRA into a Roth account, allowing your money to grow tax free. This means that you won’t have to pay income taxes on it when you withdraw from the account. (You should note, though, that there are still income restrictions on contributions to a Roth IRA. Those haven’t been lifted for this year. You can only do a rollover.) However, before you jump on the Roth IRA conversion wagon, there are a few things you should consider. Here are 6 things to know about the 2010 Roth IRA conversion:

  1. You will probably end up with extra taxes: When you put money in a traditional IRA, you putting the money in before taxes, lowering your taxable income. That traditional IRA money hasn’t been taxed, and the conversion treats the money your rollover to a Roth IRA as a distribution. Which means that you will have to pay income taxes on it. But once it’s in the Roth account, it does grow tax free.
  2. You can defer your conversion tax hit: Even though you will likely be taxed on your conversion, you can defer it. It is possible to report half of the income on your 2011 return, if you like, and the other half on your 2012 return. This gives you time to work things out. However, if you expect to be in a higher income tax bracket come 2011 and 2012, it might be worth your while to report the entire conversion amount this year. If you file an extension, you can procrastinate a little bit longer in making this decision.
  3. You can make a partial conversion: It’s not an all or nothing proposition. It is possible for you to make a partial conversion, only taking out a portion of what is in your traditional IRA and rolling it over into a Roth IRA. Run the numbers, maybe with a financial professional, and then figure out how much sense it makes to convert all or part of your traditional IRA accounts to Roth IRA accounts.
  4. You can act independently of your spouse: You do what you want to do with traditional IRAs in your name, and your spouse does the same with those in his or her name. What each of you does has no bearing on what the other does. This can be helpful, since you might look to see what conversions would do to your money goals and your taxes. Discuss this point especially if you are married filing jointly.
  5. It is possible to set up multiple accounts: If you are interested in trying some new things with a Roth account, you can hedge your investments with multiple Roth IRA accounts. If you have a big traditional IRA, it doesn’t mean that you have to get one big Roth IRA. Instead, consider using several smaller Roth IRA accounts as hedges. Or, make sure that you invest your money in a properly diversified manner in order to limit your risk.
  6. Reversal of your Roth IRA conversion is possible: If, after you complete a rollover, you decide that it wasn’t such a good idea after all, you can reverse your conversion. You have until October 17, 2011 to change your mind. You can even reclaim your tax hit if you decide to re-characterize your Roth IRA back to a traditional IRA.

Bottom line: There are pros and cons to making a Roth IRA conversion. If you think that you are going to be in a relatively high tax bracket during retirement, this might be a good time to convert a traditional IRA to a Roth IRA to avoid having your distributions count as income down the road. But you will have to do a cost benefit analysis to ensure that the tax hit you take now is outweighed by tax savings down the road.