Roth Conversions || 401(k) Plans

August 3, 2010

You may have heard or seen a lot recently about converting your 401k or traditional IRA to a Roth IRA. That's because certain rules took effect at the beginning of the year that make 2010 an ideal time to consider making such an investment decision. Introduced in 1997, Roth IRAs generally grow tax free. Unlike with a regular IRA, there is no tax deduction for contributions made to a Roth IRA. However, when withdrawals are made from a traditional 401k plan or IRA, the original investment and any income earned on it are both subject to taxation.

One of the big complaints regarding Roth IRAs is that they are subject to income limits. In 2010, individuals may contribute up to $5,000 to a Roth IRA; persons over age 50 1/2 have the ability to make up to an additional $1,000 catch-up contribution. However, individuals may not be eligible to make contributions to a Roth IRA at all depending on their adjusted gross income (AGI). For single and joint filers in 2010, Roth IRA contributions begin being phased out at a modified AGI of $105,000 and $166,000, respectively, and are completely eliminated for those with AGI in excess of $120,000 or $176,000, respectively.

In the past, if your AGI was greater than $100,000, you were not able to convert to a Roth IRA. In order to pump tax money into the federal government, this income limit has been eliminated beginning in 2010. While you will have to pay taxes on a Roth IRA conversion, in 2010 you have the option of electing to defer the tax payment by claiming half the income in 2011 and half in 2012. The deferral option expires in 2011 so conversion in subsequent years must be included in income that tax year.

The elimination of the income limit for Roth conversions means that many people who have never been able to take advantage of a Roth IRA before (and still won't be eligible to make new contributions to one) will now have the opportunity. In addition to the obvious benefit of tax-free growth on any assets converted, Roth IRAs have no minimum distribution requirements at 70 1/2. This means that you can also reduce the future taxable amount of your estate if you are hoping to leave your IRA to your children.

Whether a Roth conversion makes sense for you may depend on a number of factors, including your tax bracket now versus your expected tax bracket, how many years you have until retirement, and your current ability to pay the tax on the conversion. While you can find a number of Roth IRA conversion calculators on the Internet, the best bet is to not make any decisions until you have consulted with a financial advisor or tax professional.

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