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What’s That Roth Rollover Opportunity? And Should You Do It?

Vicki Contavespi
Posted on Dec 23, 2009

On January 1, 2010, a HUGE opportunity will be coming your way. The IRS has come out with a great new tax law affecting retirement plans, and that law may result in your having tens of thousands of extra dollars upon retirement. Under the new provision, everyone will have the chance to convert his or her traditional IRAs into Roth IRAs. (Previously, one had to earn an adjusted gross income (AGI) of less than $100,000 per year to be able to convert, but starting in 2010, everyone will be allowed to do it.)

Huh?

roth ira conversion

Deep breaths. We’ll demystify.

We feel strongly that every LearnVester needs to take the time to evaluate whether taking advantage of this new legislation is right for her. So, please read this carefully … and reread it, if need be. And, rest assured, if you still have questions after reading this Daily, we are here to help you. We can be reached at feedback@learnvest.com for additional expert advice.

The Scoop

Both a traditional IRA and a Roth IRA are retirement plans.  (To learn more about the traditional IRA and the Roth IRA, click here.) The key difference between them is this: With a Roth, you pay taxes when you contribute the money rather than when you withdraw—so your earnings grow tax-free.

Now, is it in your best interest to convert from a traditional IRA to a Roth IRA? Probably yes, but ask yourself these questions first:

1. Do you have enough money to pay the income tax on the converted IRA amount?

Basically, with a Roth IRA, you pay taxes when you make your contributions, and then never again. That’s great news. But, if you move your money from a traditional to a Roth IRA, then those funds will be considered income at the time of conversion. As a result, you’ll have to pay taxes on them.  So, switching from traditional to a Roth will cost you some tax money in the short term, but it’s in exchange for lots of savings later. Still, make sure you have the money to cover yourself if you make the near-term switch.

2. Is your future tax rate likely to be the same or higher than your current rate?

That’s almost definitely a yes for most people. This means that you would rather pay taxes now than when you’re ready to retire (because there will be less to pay!).

3. Will you leave the converted funds in the Roth IRA for five years or more?

Most likely yes, unless you’re in your mid-50s. Be aware that you’ll face a 10% early withdrawal penalty—and income tax—if you want to get your money out before you’re 59.5 years old. But as long as your money will be in the Roth IRA for a long time to come, then converting will be in your interest.

If all three answers are yes (which they most likely are!), then we recommend going through with the conversion to a Roth IRA.

Want to see if the conversion is definitely right for you? We think the folks at SmartMoney.com have put together a great calculator to help you make the decision.

Still have questions?  E-mail us a feedback@learnvest.com and we will respond with advice just for you—in addition, we will post your question and our response for the community.

What's New

  • SM

    Thanks for this helpful post. Can you help to clarify something for me? Lets say you retire in your late 40s. By the time you can withdraw the money, you have no income and therefore are not being taxed. How does that situation work? Are your IRA or 401K taxed at your last income tax level, or are you not taxed, since you are not working?

    • The LearnVest Staff

      Hi – thanks for your question. Your taxable rate in any given year is based on qualifying income during that year, not previous years. While social security benefits generally don’t count towards taxable income other income such as wages, self-employment income, interest, dividends will. You may be in a lower tax bracket than you are currently at retirement, but the power of compounding interest on investments over a long period of time may still make it beneficial to have distributions come out tax free at retirement.

  • Allison

    can you roll over the traditional IRA into an existing Roth, or would a new Roth have to be opened?

    • The LearnVest Staff

      Allison -

      Thanks for your question.

      Each conversion from a traditional IRA into a Roth IRA requires that a brand new Roth IRA account be opened. Since you can spread the conversion over multiple years this might mean you have to open several new accounts. You will be able to consolidate all the accounts into a single Roth IRA after the recharacterization period ends.

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  • Lou

    What if you contribute to a Roth IRA at the start of the year and then make more then the amount allowed to contribute to a Roth IRA and so you recharacterization it to a traditional IRA. Can you then go and do a Roth conversion? Or is there a way to do everything in one step so that the first recharacterization is not necessary?

    • The LearnVest Staff

      Hi Lou,

      Great question! As annoying as it may be, in this instance, you’d have to do a recharacterization to the traditional IRA. This can probably be done over the phone with the custodian of the assets. You will then need to go ahead and do the Roth IRA conversion for 2010. Operationally, you’ll end up in exactly the same place, but you need to create a paper trail for the government.