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Are You a Good Candidate for a Roth IRA Conversion?

Should You Convert Your IRA to a Roth?

In 2010, everyone is eligible for a Roth IRA conversion, regardless of income. The government is offering an incentive to convert, by allowing taxpayers to postpone the taxes due from a conversion in 2010 until tax years 2011 and 2012. Here's a summary of the benefits so you can consider whether a Roth conversion might make sense for you.

1) Once you complete the conversion and pay the taxes due, you and your heirs will never again have to pay income tax on earnings or withdrawals from the Roth account, provided you postpone withdrawals until after:

a) age 59&1/2, AND;
b) five years from the date of conversion (regardless of age).

(Gains on early withdrawals from a Roth IRA are subject to income tax plus a 10% penalty. These are waived for withdrawals of up to $10,000 for a first-time home purchase, or for any withdrawals in the case of permanent disability or death.)

2) During your lifetime, there are no required minimum distributions (RMDs) from a Roth account. Anyone who inherits a Roth account from you must take distributions during their lifetime, but will not have to pay income tax on those distributions.

3) With no RMDs, your annual income will be lower. Lower income could allow you to reduce or avoid some tax hits that kick in at income levels above certain thresholds:

a) The phaseout of exemptions and itemized deductions based on Adjusted Gross Income.
b) Tax on Social Security benefits.
c) Increase in the cost of Part B of Medicare.
4) Unlike a traditional IRA, you can continue to contribute to a Roth IRA after age 70 ½, as long as you have income that does not exceed certain levels.

Making the Most of Your Roth IRA Conversion.

So you have decided that a 2010 Roth conversion makes sense. What measures can you take to minimize your tax liability and the impact on your financial resources, and at the same time maximize your gains and flexibility?

1. Pay the tax liability attributable to the conversion from funds outside of your retirement accounts. The benefits of a Roth conversion are greatly diminished if funds from the conversion are used to pay the resulting tax bill.

2. If you need to sell securities to cover the taxes, start with fixed income. You would be selling assets that were not significantly affected by the market downturn and giving your "depressed" assets time to regain their value as the stock market recuperates.

3. Split the converted amount into separate Roth accounts. For example, you convert a $200,000 IRA. Your investment strategy for this portion of your portfolio calls for an even split between U.S. stocks and foreign stocks, so you setup two $100,000 Roth IRAs. A year later (before you file your 2010 tax return), the U.S. stocks have increased in value but the foreign stocks have dropped 50%. You can recharacterize the $100,000 foreign stock Roth back to a traditional IRA and so eliminate the tax that was due on it. You will owe tax only on a $100,000 Roth conversion and the amounts in the U.S. stock account continues to grow tax-free.

4. Plan ahead and monitor your taxable income and tax rates. The converted amount can be included on your 2010 return OR be reported evenly on your 2011 and 2012 tax returns. If you believe your income -- or tax rates -- will be significantly higher in 2011 and 2012, you may elect to forego the tax deferral. In addition, through deferring income and accelerating deductions for any or all of the years involved, you may be able to further minimize the tax impact of the conversion.

As you can see, decisions related to a Roth IRA conversion are specific to your own individual circumstances and expectations for the future. Careful planning and implementation is necessary to make the most of your Roth IRA conversion.

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About the Author

Michael Byman, Alexandria Capital
1030 15th St NW, Suite 450
Washington, DC 20005
202 391 0174

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