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Recession could make conversion to a Roth IRA advantageous

Sarah C. Rieger

Q. What is a Roth IRA? Also, I keep reading something about new laws concerning Roth conversions. Can you explain?

– Cynthia H.

A. The topic of Roth IRAs has been all over the news lately because of some recent changes that allow investors to convert their IRAs to a Roth IRA.

Let me review some basics: IRA stands for Individual Retirement Account. The Roth IRA was named after the late Sen. William V. Roth, of Delaware, who helped bring this type of retirement savings into being.

A traditional IRA is funded with contributions of pre-tax dollars up to an annual limit; in 2010 that limit is $5,000, or $6,000 if an individual is over the age of 50. The funds grow tax-deferred until the investor retires, and taxes are paid when the funds are withdrawn, after age 59 1/2. Taxes are paid on the contributions, earnings and growth. This type of retirement savings is considered tax-deferred.

With a Roth IRA, an investor saves after-tax dollars up to the same annual limits, and those funds grow tax-free. That means when the investor retires and withdraws money, he or she doesn’t have to pay taxes on it. An investor can covert a traditional IRA to a Roth IRA, but there have been some rule changes recently. Previously, only investors with income of $100,000 or less could convert an IRA to a Roth IRA. Starting this year, the income threshold has been lifted, so anyone can make the conversion.

When an IRA is converted, income taxes are charged on the amount converted. Those taxes used to be paid in the year of conversion, but now they can be spread over two years.

With the recent recession, many investors’ IRA balances are down in value. In addition, many investors’ earned incomes are down, putting some in a lower tax bracket. If this is your scenario, it may be advantageous for you to consider converting your IRA to a Roth.

If you have savings that you could use to pay the taxes due on a conversion, I think this may be one of the best planning strategies for 2010.

But you should seek out a financial planner or an accountant to run the numbers.

Sarah C. Rieger is a certified financial planner and member of the local Financial Planning Association chapter. Readers are invited to submit questions on financial planning to be answered in this space each Tuesday. Send questions to askaplanner@spokesman.com.