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Overeating isn’t the only cause of acid indigestion during this start of the holiday season. The other reason is that investors are examining their year-end statements and seeing the dramatic decline in value in just the past twelve months. This is especially true of those with IRAs and it raises many questions. Should they change the asset allocations? Continue to make contributions? What about switching to a Roth IRA?

First, let’s define the difference between a traditional IRA and a Roth IRA. With the traditional, the proceeds that are withdrawn are taxable. With a Roth, the withdrawals are tax free. But in order to make this conversion to a Roth, you have to pay current income tax on your IRA deposits in order to be eligible. This is precisely the reason that the timing could be right. With the markets declining values, it makes sense to pay income tax on the assets while they are half price or lower. Ironically, this might be one of the only advantages to the diminished value of your IRA- it is creating opportunities you would never have otherwise considered.

In order to convert to a Roth IRA by year’s end, there are ground rules. First, you are only eligible if your annual earnings are $100,000 or less (this limitation will change in the year 2010 when there will be no income restrictions). Secondly, unlike a premature withdrawal from a traditional IRA, a Roth IRA does not have a ten percent penalty. However, you must wait five years and be older than 59 ½ to fully take advantage of these tax-free withdrawals. This conversion obviously favors those who have a long period of time for the assets to grow and to recover from the declining market values, but also to not be as hurt by the initial tax hit.

Consider the math. Let’s say you are considering the conversion to a Roth IRA and you had $10,000 in your current IRA. Today it’s worth $5000. In order to be eligible, you would have to pay tax on the $5000, and for the purpose of this example, you are in a 15% tax bracket. Your income tax liability would be $750 to convert the IRA leaving you with the balance or $4250. Obviously the more time you have to let it grow in a tax- free situation the more the time you’ll have to surpass the cost of paying the tax early and hopefully growing back to the original value of $10,000. However, when you eventually draw out $10,000, remember that it will be income tax free.

To convert or not to convert is the question. The answer lies within how many years you have left until retirement, but if you do make the switch, it is one conversion that could be the answer to your prayers.

What I Know That You Need To

Q. If I reach age 70 ½ and I’m required to withdraw minimum distributions from my IRA, is my Roth IRA exempt from this requirement?

A. Yes, you are exempt. There are not minimum distributions required with a Roth IRA.

Q. Can I contribute my 401k deposit into a Roth IRA?

A. Yes, most plans now offer you the choice to make your 401k deposit into a regular or deductible account or to pay the upfront taxes on deposit in the 401k. Many people consider that even though they are paying the tax up front, the tax would be negligible if their deposit grew over the years and was never subjected to any income tax.

Q. Are there circumstances under which you don’t recommend a Roth IRA?

A. Generally, those who are closest to their retirement may not gain full advantage of the tax free nature of the Roth because they are too close to needing to draw the money out and the tax deduction is far more important in the short term especially for those in a high tax bracket.

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Tags: cfp, financial planning, ira, lee rosenberg, roth ira

About the Author: Lee Rosenberg is the Co-founder of ARS Financial Services, Inc. As a Certified Financial Planner with more than 34 years of solid financial expertise. Lee is a registered representative of Cadaret, Grant & Co., Inc. He was also named one of the top 25 Independent Financial Advisers in the US by Rep magazine.

This entry was posted on Monday, June 22nd, 2009 at 9:48 am and is filed under ira. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.