Thinking of converting to a Roth IRA? A partial conversion may help you spread out your tax payments.
Now that income limits have been eliminated for Roth IRA conversions, a growing number of investors are taking advantage. While there are tax considerations, converting your Traditional IRA or employer-sponsored retirement account to a Roth IRA may offer you more flexibility and control over your nest egg in retirement.
Anyone can convert.
If income limits precluded you from making contributions in the past, you may be happy to hear that, due to changes in the law in 2010, there are no modified adjusted gross income (MAGI) restrictions for Roth IRA conversions. As of January 1, 2010, anyone can convert a Traditional IRA or other eligible retirement plan assets1 to a Roth IRA, as long as taxes are paid on the conversion (i.e., pre-tax) amount. This change represents an opportunity for investors who wish to potentially lessen their tax burden in retirement and enjoy greater flexibility. Of course, every financial situation is unique, so please consult with a tax advisor to get help in determining whether converting to a Roth IRA is right for you.
But not everyone can contribute.
While everyone is eligible to convert to a Roth IRA, due to income restrictions, many taxpayers are prohibited from directly contributing to Roth IRAs. For example, if in 2012, your MAGI exceeds $125,000 as a single taxpayer, or $183,000 as a joint-return taxpayer, or if you are a married taxpayer who files separately and your MAGI exceeds $10,000 - you are not eligible to contribute to a Roth IRA.
For 2012, eligible investors can contribute up to $5,000 (or $6,000 for those age 50 or older), but the contribution limit declines for single taxpayers with MAGI of more than $110,000 or married couples filing jointly with MAGI of more than $173,000.
It's not an "all or nothing" proposition - consider a partial conversion.
Pre-tax assets that are converted from a Traditional IRA or another eligible retirement plan to a Roth IRA are treated as a taxable distribution and are subject to ordinary income tax rates in the year of the conversion. For conversions made in 2010, a special tax provision allowed investors to spread the income from the conversion over two years' tax returns: 2011 and 2012. While that provision has expired, the same benefit can be realized through a partial conversion - that is, converting a portion of your money assets over two years or more, thereby spreading out your Roth IRA tax payments.
Converting to a Roth IRA may be worth considering if you:
- Have assets invested in Traditional IRAs or employer-sponsored retirement plans.
- Think you'll be in a higher tax bracket in retirement, or if you're temporarily in a lower tax bracket now.
- Can afford to take the tax hit now without dipping into your retirement account to pay the conversion taxes.
- Have unused tax deductions (such as charitable contributions or medical expenses) that can help offset the income generated by the conversion.
- Wish to reduce the taxable value of your estate or potentially leave income tax-free assets to your heirs.
Understanding Roth IRAs.
There are a variety of factors to consider before you determine whether to convert your assets to a Roth IRA. Again, you should consult with a tax professional to assess the potential impact on your long-term financial goals before making any decisions.
How do they work?
Your assets will grow tax-deferred and can be distributed tax-free (on a federal and possibly state level) after five years if:
- You are age 59 ½ or older.
- You qualify for a special purpose distribution such as the purchase of a first home (lifetime limit of $10,000).
- You die or become permanently disabled.
If you make a withdrawal that does not meet these or certain other qualifications, you will owe ordinary income tax on the taxable portion of your distribution and, potentially, a 10% additional tax for withdrawals prior to age 59 ½.2
What are the benefits?
Now that income restrictions have been lifted on Roth IRA conversions, many investors are taking a hard look at the potential benefits - primarily, tax-free withdrawals and no mandatory distribution schedule - to determine whether a switch makes sense.
- Avoid future taxation - While Roth contributions are not tax deductible, qualified distributions are federal (and possibly state) income tax-free. This is a great perk if you anticipate being in a higher tax bracket when you withdraw your money - typically in retirement. Many investors hold a significant portion of their retirement savings in a tax-deferred plan - such as a 401(k) or other employer retirement plan - money that is taxed upon distribution. Converting some of your savings to a Roth IRA (accomplished through a partial conversion) allows you to diversify your retirement assets from a tax perspective.
- Enjoy greater flexibility - Roth IRAs offer you greater withdrawal flexibility. Unlike a Traditional IRA, Roth IRAs are not subject to required minimum distributions (RMDs) for the original account holder, so you are not required to begin taking distributions at age 70 ½. You can also continue to contribute to your Roth IRA account for as long as you earn income, even after turning age 70 ½ (which is a feature that is not permitted for Traditional IRAs).
Key points to remember.
- Partial conversions provide the same benefits as provided under the 2010 tax law - enabling you to spread out your tax payments over multiple years.
- There are no longer income restrictions on Roth IRA conversions — anyone can make the switch.
- Roth IRAs generally provide federal (and possibly state) tax-free income in retirement and greater flexibility when it comes to distributions.
- Be sure to consult a tax advisor before making your decision.
Learn more about a Roth IRA conversion.
Compare Roth and Traditional IRAs and see how the benefits stack up.
Take the Next Step with Merrill Edge
Self-directed investors can open a Merrill Edge Roth IRA account online. Need professional advice and guidance? Call the Merrill Edge Advisory Center at 1.888.MER.EDGE to open an account.