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To Roth or not to Roth—that is the question

By Don Kuehn

Whether 'tis nobler to suffer the slings and arrows of future taxation, or to pay up now and reap the benefits of tax-free withdrawal after retirement (apologies to the Bard) is a good question. I thought this was going to be a slam-dunk article until I started researching the topic.

New laws are in effect that make 2010 a great year for many people to convert their traditional IRA accounts into a Roth IRA. For others, however—not so much.

The basics: Traditional IRAs allow contributions to be made before taxes to grow free of annual taxation until withdrawn (after age 59½) when the then-current tax rates will apply. Minimum annual distributions are required at age 70½.

A Roth IRA permits after-tax contributions of money to be invested in an account that grows free of taxes forever, with no annual distributions required at any age. After age 59½, and assuming the account has been open for more than five years, one can withdraw from a Roth account and never pay taxes on the growth of the investments. Sweet!

Because of the tax-free withdrawal feature and the fact that there are no required annual distributions, Roth IRAs are a favored tool in estate planning. Accounts grow untouched, and beneficiaries can receive a tax-free inheritance separate from other assets that may be passed on.

This year, the contribution limits for both kinds of IRA accounts are $5,000 if you are under age 50 and $6,000 if you are older. The limits phase out depending on income and tax filing status and are affected by your participation in an employer-sponsored retirement plan.

Also—only in 2010—converting from a traditional IRA to a Roth brings with it an option to apply the taxes due entirely to this year’s earnings or to apply one half to 2011 and the other half to 2012. The tax code allowing these conversions is permanent, but the provision for the payment of taxes to be spread out over two years applies only to conversions made this year.

Making the conversion isn’t hard. You just have to contact the custodian of your traditional IRA who can walk you through the change. The decision as to whether making the conversion will benefit you is a little trickier.

First, you need to be able to pay the additional taxes from other resources. Don’t cannibalize your nest egg by trying to pay the extra taxes out of proceeds from the conversion. You may subject yourself to a 10 percent penalty for early withdrawal.

You could start a special savings account now, and try to put aside enough to cover the additional taxable income when you file your 2010 taxes (or your 2011 and 2012 taxes if you choose that option).

Second, if you believe your adjusted gross income is likely to increase in 2011 or 2012 subjecting you to “bracket creep,”—or that marginal tax rates in general could be higher—you could talk yourself into paying higher taxes on the converted amounts.

I spoke to my tax preparer about the dreaded alternative minimum tax (AMT) that many people have to contend with. I asked if converting to a Roth would make it more (or less) likely that a person would be subject to the AMT.

He said it could, indeed, make it more likely that you would have to deal with the AMT in the years that you declared the added income, but that to him, “It isn’t a deal breaker because even if you had to pay AMT next year, if your income falls below a set threshold (depending on your filing status) you can claim AMT credit in subsequent years. And the benefit of tax-free accumulation for the rest of your life far outweighs the cost if you are young enough to recoup the tax hit.”

Third, the pay-back period—how long it will take for interest and dividends earned on the money in your account to equal the taxes you will pay in the short term—can stretch to 15 or 20 years, depending on the rate of return on your investments. Clearly, the younger you are and the more time you have before you are going to need to withdraw from these accounts, the better.

Fourth, if you are sure that your tax bracket will be lower after retirement, it might be a smart move not to convert.

Fifth, if your income was too high to allow you to open or convert to a Roth IRA in the past, this is a good way to get around the rule. You still may not be able to contribute new money to your Roth, but the income limits that precluded your participation in this plan do not apply to conversions done in 2010.

Finally, if you don’t have a tax preparer, get one. The decision to convert is tricky and will have consequences for a long time. There are loopholes—way too complicated to get into here—that a tax expert can steer you through, and ways to take advantage of the law to get the most out of the money you have stashed away for retirement or that you hope to pass along to your heirs.

“To Roth or not to Roth” is a question complicated enough to warrant the advice of your tax accountant and your financial planner. It may be as simple as deciding whether you are better off paying taxes when you plant the seeds of retirement (a Roth IRA), or when you harvest them (a traditional IRA).

It’s your money—make the most of it.

Don Kuehn is a retired AFT senior national representative. For specific advice relative to your personal situation, consult competent legal, tax or financial counsel. Comments and questions can be sent to