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The Roth IRA Conversion Dilemma
January 17, 2010
Throughout 2010, you will be awash in conflicting opinions about whether or not converting your traditional IRA to a Roth IRA is a good financial move.
By way of background, anyone at anytime can convert a traditional IRA to a Roth if they meet the qualifications. Up until 2010, there had been an adjusted gross income threshold above which you could not convert. That amount was $100,000. In 2010, there is no constraint due to income so now everyone has an opportunity to convert. The second critical qualification is to pay the income tax on the funds withdrawn from the traditional IRA in the year of conversion. With a 2010 conversion, the IRS will permit payment of the tax over 2 years.
The decision to covert is more complicated than just abiding by the two qualifying factors I just mentioned. A qualified tax expert should be consulted so you understand all of the tax ramifications about doing a conversion.
I want to shift gears and present a financial analysis of the conversion decision that examines more closely the consequences of paying the income tax upon conversion. In the parlance of finance, there is what is known as the opportunity cost - the measure of what is lost or what is not gained by using money that could otherwise be invested for a higher return, particularly if there is a long term time horizon in front of you.
I have published several articles on this topic. They are all posted within this blog. I invite you to read each article and hopefully you will have the information you need to determine the next step about executing a conversion in 2010.
In my opinion, your income tax status before and after the conversion has to remain essentially the same throughout your life, your beneficiary's life and the lives of any subsequent beneficiaries for a conversion to be income tax neutral. Otherwise there could be negative permanent tax differences that might disqualify the conversion because of the opportunity cost I previously mentioned.
Those of you have built up substantial traditional IRA balances will also have substantial deferred tax benefits within the account that stretch decades into the future. You need to be concerned about converting these deferred income taxes to an immediate income tax liability, which is why a more rigorous analysis has to be done before making a decision.