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Switching to a Roth Takes Tax Planning

In 2010, income limits have been lifted for Roth conversions. It's time for some tax planning.

EDITOR'S NOTE: This article, originally published in the August 2009 issue of Kiplinger's Retirement Report, has been updated in January 2010. To subscribe, click here.

As of January 2010, just about anyone is able to convert a traditional IRA to a Roth IRA. With depressed account values and relatively low tax rates, this could be a great opportunity to set the stage for a tax-free retirement.

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Previously to qualify for a Roth IRA conversion, your modified adjusted gross income had to be $100,000 or less, whether you were married or single. But that income limit disappeared in 2010. Also, for the first time, married couples who file tax returns separately are eligible for a Roth conversion.

And Congress threw in an extra goody. Usually, when you convert from a traditional IRA, you pay income tax on the amount you move into the Roth with the tax return for the year you made the conversion. But for 2010 conversions, you can delay paying Uncle Sam for a year and then report half the amount on your 2011 return and half on your 2012 return. "One of the biggest benefits for those converting in 2010 is you get three years to pay the tax," says Shane Barber, a financial adviser at Barber Financial Group, in Lenexa, Kan.

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Why convert at all? Once the money is in a Roth, it will grow tax-free, and account holders are not required to take minimum distributions. If income-tax rates rise, a pot of tax-free retirement income could help lessen your future tax burden. And without RMDs, if you don't need the money, the pot will grow larger, leaving more tax-free money for your heirs.

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If you decide to convert, you need to engage in some careful planning. For one thing, you should figure out how to come up with the cash to pay the tax bill without dipping into the IRA. Depleting the amount in the tax shelter to pay for the conversion undermines the value of the switch. If you plan to sell stocks or mutual funds to raise the cash, you will want to choose the assets judiciously to hold down your tax liability.

It's usually a good idea to put off paying any tax bill that you can, so you can hold on to your cash. Splitting the amount of income reported in 2011 and 2012 could keep you in a lower tax bracket. Also, pushing off the due date gives you more time to save money outside the IRA to pay the tax bill.

But there is a danger in waiting. Your taxes will be based on the rates in effect for 2011 and 2012, and President Barack Obama is pushing hard to raise rates on higher-income individuals. "If tax rates change significantly, you could end up paying the tax at a higher tax rate," Barber warns.

Figuring Out Future Tax Rates and Brackets

If it appears likely that you'll be in a higher tax bracket in 2012, it may not make sense to defer the tax bill, says Natalie Choate, an estate-planning lawyer with Nutter McClennen & Fish, in Boston. But, she says, if you'll be retiring in 2010 and expect your tax bracket to drop a lot, then you'd probably want to defer and split the tax bill. "You won't have to decide until you file your tax return for 2010," says Choate.

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There are middle-of-the-road options for how much of your IRA you might convert. "The conversion decision doesn't have to be all or none," says Place. You could convert part of your traditional IRA to a Roth one year and another part in a subsequent year. You may also be able to push and pull other sources of income into different tax years to help lessen your overall tax burden in a particular year.

One thing Congress hasn't changed: You can't make new contributions to a Roth IRA if your modified AGI is higher than $177,000 for married couples and $120,000 for singles. You can skirt this restriction by making nondeductible contributions to a traditional IRA and then converting the IRA to a Roth in 2010 or beyond.

For more authoritative guidance on retirement investing, slashing taxes and getting the best health care, click here for a FREE sample issue of Kiplinger's Retirement Report.

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