Roth IRA conversions: benefits and planning opportunities.

• Author: Detzel, Lauren Y.
• Position: Individual retirement accounts

By now, everyone knows the benefits of making contributions to an individual retirement account (IRA) as well as taking advantage of an employer's 401(k) plan. To sum it up in one phrase, it's tax-free compounding. The ability to grow an investment account tax-deferred over the course of 20, 30, or even 50 years exponentially increases the amount a person can accumulate, whether it is for retirement or to leave to his or her heirs.

For certain individuals, a Roth IRA, as opposed to a traditional IRA, may be more beneficial to meet that individual's goals. This article examines the potential benefits of converting a traditional IRA (or an employer-sponsored retirement plan) to a Roth IRA and the possible ways in which a person can convert his or her traditional IRA into a Roth IRA.

Traditional IRA vs. Roth IRA

There are two types of IRAs, the traditional IRA and the Roth IRA. Contributions to a traditional IRA are made with pretax dollars. Money contributed to the traditional IRA is, therefore, deductible on the taxpayer's individual income tax return. (1) Because the contributions to the traditional IRA are made with pretax dollars, distributions received from a traditional IRA are taxable as ordinary income. (2)

By contrast, contributions made to a Roth IRA are made with after-tax dollars and are not deductible. (3) As a consequence, qualified distributions received from a Roth IRA are not subject to income tax. (4) Because a Roth IRA is made up of after-tax dollars as opposed to pretax dollars, a Roth IRA is worth more than a traditional IRA with the same account balance. The easiest way to look at this concept is by viewing it as if the government actually "owns" a portion of a traditional IRA because the distributions are taxable. The exact percentage of the traditional IRA that the government "owns" depends on the individual's marginal income tax rate when distributions are made from the traditional IRA. The government, however, has no stake in any portion of the Roth IRA because the qualified distributions are wholly exempt from income taxes. Thus, someone with a traditional IRA with a balance of $100,000 actually has an after-tax interest in the traditional IRA of something less than $100,000. Whereas an individual who has a Roth IRA with a balance of $100,000 has an after-tax interest in the Roth IRA of the full $100,000.

The traditional IRA and the Roth IRA have the same annual contribution limits. For 2009, an individual under 50 years of age can contribute up to $5,000 per year into either a traditional or a Roth IRA, while an individual age 50 years and over can contribute up to $6,000 per year. (5) For a traditional IRA, an individual who is over 70.5 years of age cannot make any additional contributions; however, an individual can continue to make contributions to his or her Roth IRA after the age of 70.5, subject to the annual contribution limits. (6)

Although the contribution limits are the same for traditional and Roth IRAs, not all taxpayers qualify to make contributions to a Roth IRA. For single taxpayers, the amount that may be contributed to a Roth IRA is phased out once their modified adjusted gross income is $105,000, and no contributions to a Roth IRA are allowed once their modified adjusted gross income is $120,000. (7) For married taxpayers, the phase-out begins when their combined, modified adjusted gross income reaches $166,000, and if their combined modified adjusted gross income exceeds $176,000, then no Roth IRA contributions are allowed.

A substantial difference between the traditional IRA and the Roth IRA is the distribution requirements. For a traditional IRA, the IRA owner must start taking distributions from the IRA by April 1st of the year following the year in which the taxpayer becomes 70.5 years old. (8) The amount of the required minimum distribution is determined based upon the IRA owner's life expectancy. Thus, it is likely that a large portion of a traditional IRA will be distributed to the original IRA owner during his or her life.

Unlike a traditional IRA, a Roth IRA has no required minimum distributions during the participant's lifetime. (9) Thus, if the participant does not need to take distributions from the Roth IRA during retirement, the Roth IRA can continue to grow, tax-free, over the remainder of his or her lifetime. These additional years...