Roth IRA conversion deserves second look

If you’re holding money in a traditional IRA, maybe it’s time for you to take another look at a Roth conversion.

Since the $100,000 income limitation was removed in 2010, you have no restriction on your ability to transfer funds from a traditional IRA to a Roth IRA – and no limit on the amount you can transfer.

You will have to pay tax currently on the amount of the transfer that would have been treated as a taxable distribution, if you had actually received the money. But the future benefits can be significant.

Future distributions, including profits, from the Roth account will escape tax entirely, provided you have had a Roth account in place for at least five years. Moreover, there is no required minimum distribution when you reach age 70 1/2.

Statistics recently released by the IRS for 2010 – the latest year for which information is available – show that wealthier people are taking advantage of the Roth conversion opportunity in record numbers. Conversions increased more than nine times in 2010, rising to $64.8 billion from $6.8 billion in 2009, according to IRS data. That was the first year in which Roth conversions exceeded contributions.

The wealthiest Americans – those with estates large enough to be subject to the estate tax – receive an additional benefit. Any income taxes paid as a result of the conversion reduce future estate taxes. Without the conversion, the heirs will eventually pay the income taxes anyway, so the estate tax savings is a net benefit to the family.

A Roth conversion may not be for everyone, but you may wish to take a second look. If you convert in early 2014, you may not have to pay the resulting income taxes until April 15, 2015. That gives you more than a year to continue to use those tax dollars to enhance your retirement savings.

With the IRS relaxing the rules on in-plan Roth conversions, your 401(k) plan should also be considered as a conversion candidate if it offers a Roth account feature.